108 finance and finance reporting (actuarrial)

Faculty of Actuaries Institute of Actuaries

EXAMINATIONS

13 April 2000 (pm)

Subject 108 — Finance and Financial Reporting

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Write your surname in full, the initials of your other names and yourCandidate’s Number on the front of the answer booklet.

2. Mark allocations are shown in brackets.

3. Attempt all 19 questions, beginning your answer to each question on aseparate sheet.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet and this question paper.

In addition to this paper you should have availableActuarial Tables and an electronic calculator.

Faculty of Actuaries108—A2000 Institute of Actuaries

108—2

For questions 1–5 indicate in your answer booklet which one of the answers A, B, C or Dis correct.

1 In certain circumstances the Stock Exchange may grant a quotation for acompany even though the company is not making any new shares or existingshares available to the market.

This method of obtaining a quotation is known as:

A A placingB A tender issueC An introductionD A prospectus issue [2]

2 The following information relates to the ordinary shares of F plc:

Earnings per share 50pDividend cover 2.5 timesPublished dividendyield

3.2%

The price of F plc’s ordinary shares implied by the above data is:

A 78pB 625pC 1563pD 3906p [2]

108—3 PLEASE TURN OVER

The following information relates to questions 3 and 4.

X Ltd’s Balance sheet as at 31 December 1999 included the following items:

£ Total assets less current liabilities 125,000 9% Debentures (repayable 2004) 20,000

105,000

Ordinary shares of 50p each 50,000 10% Preference shares of £1 each 20,000 Reserves 35,000

105,000

3 X Ltd’s profit before interest and taxation for the year to 31 December 1999was £40,000.

X Ltd’s company’s Return on Capital employed for the year ended 31December 1999 is:

A 32%B 38%C 44%D 47% [2]

4 X Ltd’s interest cover is:

A 6.6 timesB 10.5 timesC 13.9 timesD 22.2 times [2]

108—4

5 A company’s ordinary shares have a current market price of £2. The companyis making a 2 for 5 rights issue at a price of £1.50.

What is the ex-rights price?

A £1.50B £1.74C £1.86D £2.60 [2]

In questions 6–10 one or more of the options may be correct. Answer in your booklet byselecting according to the following code:

A if I and II only are correctB if II and III only are correctC if I only is correctD if III only is correct

6 Which of the following assets are not intangible fixed assets?

I Research costsII Trade marksIII Development costs [2]

7 Which of the following is true:

I Depreciation adjustments are attempts to reflect the value of fixedassets in the balance sheet.

II Depreciation is an application of the matching concept.

III Depreciation is a measure of the wearing out or consumption of afixed asset over time. [2]

8 Which of the following statements about preference shares is correct?

I Preference shares carry fixed dividend rights.

II Preference dividends can be suspended if the directors decide that thecompany cannot afford to pay them.

III Preference shareholders never have any voting rights. [2]

9 An ordinary share may have a high dividend yield because:

I Dividend cover is high.II It is cheap.III Dividend growth prospects are poor. [2]


10 Chargeable gains on the disposal of the following assets are not subject tocapital gains tax:

I Any residential properties.II Private motor cars.III British government securities. [2]

11 The directors of Sawburn plc have decided to investigate ways in which theymight improve their management of short and medium term finance. Thecompany’s business involves irregular inflows and outflows of cash. Thedirectors have tended not to rely on bank overdraft in order to deal with cashshortages, preferring to use short fixed term loans instead. They are nowconsidering a change to this policy because of the greater flexibility ofoverdraft finance. They have decided that this might reduce finance costsbecause interest is only paid on overdrafts on the amount by which the accountis actually overdrawn.

Describe the factors that the directors should take into account in making thischange of policy and explain whether overdraft is likely to be the most suitableform of short term finance in these circumstances. Your answer should makeappropriate references to the alternatives to overdrafts. [8]

12 The directors of a company are planning to undertake a rights issue. Describethe factors that should be taken into account in deciding whether to have thisissue underwritten. [6]

13 Explain what is meant by the term “associate company” and explain howassociates are treated on consolidation. [4]

14 Discuss the proposition that ratio analysis is considered to be a useful methodof interpreting financial statements, although it has some limitations. [6]

15 A company intends to acquire a factory and £600,000 of plant and machinery.Explain the taxation implications of leasing these assets rather thanpurchasing them outright. [6]

16 Describe the main features of merchant banks and discuss their influence onthe financial markets. [6]

108—6

17 Explain how the Bank of England provides liquidity in the money markets. [4]

18 The following information has been extracted from the accounting records ofTyler plc:

Trial Balance at 31 March 2000

£000 Administration costs 800 Bank overdraft 700 Debtors 1,300 Factory — cost 23,300 Factory — depreciation 1,800 Factory running costs 1,200 Loan interest 1,680 Long term loans 12,000 Machinery — cost 15,000 Machinery — depreciation 8,000 Manufacturing wages 1,300 Materials — consumed 1,600 Profit and loss account 380 Sales 13,000 Sales salaries 1,600 Share capital 12,000 Stock at 31 March 2000 700 Trade creditors 600

Notes:

(a) The corporation tax charge for the year has been estimated at£1,290,000.

(b) The directors have proposed a dividend of £1,400,000.(c) At the year end the directors had the factory professionally revalued.

The valuer’s report estimates the value of the property at £25,000,000.This value is to be incorporated into the balance sheet.

(d) During the year the company charged depreciation of £460,000 on thefactory and £2,000,000 on the machinery. The company purchased newmachinery at a cost of £2,700,000. There were no other transactionsinvolving fixed assets. All of these adjustments and transactions havebeen incorporated into the above figures.

Prepare Tyler plc’s profit and loss account for the year ended 31 March 2000and the balance sheet as at that date. These should be in a form suitable forpublication. You should provide a note in respect of tangible fixed assets, butyou are not otherwise required to provide notes to the accounts. You should,however, clearly show your workings. [20]

108—7

19 The directors of Holt plc have introduced a formal system of investmentappraisal. Projects must have a positive net present value when discounted ata cost of capital determined in relation to their systematic risk. The board ispresently considering two unrelated projects. One is for an investment in aspeculative research project. This is fraught with potential problems becauseit is dependent on the successful application of a recent theoretical discoveryreported in the physics literature. Even if the technical problems can beovercome, there is a serious risk that another company will offer the principalscientists — who are the leading specialists in their field — more lucrativecontracts. The other project is a rather more predictable expansion of theproduction facilities for an existing product line which has a well establishedmarket.

The beta coefficient for the research project is 0.6 while that of the newproduction facilities is 1.3. The risk free rate is 3% and the risk premium is8%.

(a) Calculate the required rate of return for each of the projects. [4]

(b) Explain why it might be possible that an apparently risky project couldhave a lower required rate of return than that for a less volatile project.

[6]

(c) Explain whether company directors are likely to accept the logicunderlying the capital asset pricing model (CAPM) in practice whenthey are making investment decisions. [5]

(d) Outline alternative ways in which one might estimate the betacoefficient of a project. [5]

[Total 20]


EXAMINATIONS

April 2000


EXAMINERS’ REPORT

! Faculty of Actuaries! Institute of Actuaries

Subject 108 (Finance and Financial Reporting) — April 2000 — Examiners’ Report

Page 2

1 C

2 B

3 -

4 -

5 C

6 C

7 B

8 A

9 B

10 -

There were three small errors in questions in order to ensure no student wasunfairly penalised for this the paper was marked out of 94 and the three questionswere discounted. The remaining questions were answered well.

11 The directors should consider the cost of the different types of finance available tothem. Clearly, it is desirable to use the cheapest source unless it has some otherdisadvantage. Different types of finance involve different levels of risk for thelender and that will tend to result in different rates of interest.

The other major issue is the risks created for the company. A source of financemight leave the company open to serious penalties if it is forced to default for anyreason. For example, a secured loan will tend to be relatively cheap but mightcreate serious problems for the company if the lender calls in the security.Furthermore, the company will have a limited borrowing capacity for any giventype of finance. Exhausting this might restrict its ability to deal with futureproblems.

Bank overdrafts do provide a flexible means of dealing with fluctuatingrequirements. Most loans commit the company to the payment of interestthroughout the agreed term of the loan. Early repayment might not be permittedby the agreement or could involve an additional charge. Overdraft facilities canbe agreed with the bank and then used and as and when the company requires.The company can borrow up to its overdraft limit for as short a period as itrequires the funding. Interest will be charged on a daily basis on the actualamount outstanding.

The rates of interest charged on overdrafts tend to be quite high and so it mightprove to be an expensive source of finance if the company is likely to be heavilyoverdrawn for a large proportion of the time. Term loans might prove cheaper inthis situation because of lower rates, even though there might be short periods ofcash surplus during which the company does not actually require the funding.

One disadvantage of using the overdraft facility is that the banks are likely toimpose a restriction on the maximum amount that they are willing to advance inthis manner. Having the capacity to borrow up to the limit at short notice couldbe useful if the company has an unexpected need for cash. If part of the facilityhas been used up in the course of normal operations then the company will bemore severely constrained.


Page 3

There may be other sources of finance which would be more suitable for thecompany’s fluctuating needs. For example, debt factoring makes it possible toraise cash immediately after a sale has taken place. This has the advantage ofbringing in more cash at busier times when the company’s needs might begreater and could offer many of the benefits of overdraft without using up any ofthe actual overdraft facility.

This question was well answered by most candidates

12 The main advantage of underwriting a share issue is that there is no risk of thecompany being left with unsold shares. If the rights issue proves unattractive toshareholders then the company may have insufficient funds to finance the projectfor which the shares were being issued. It may prove difficult and expensive toraise additional long term finance by some other means.

The main disadvantage of underwriting the issue is that the company will haveto incur fees which may prove substantial. While this might be a worthwhileinvestment, it is desirable to minimise such costs wherever possible.

The rights issue is likely to prove successful if the new shares are sold at areasonable discount. While any discount is likely to make the shares attractive,the volatility of the stock market and of the company itself should be considered.If the share price is likely to move rapidly then the rights price could exceed themarket price, thereby making he new shares unattractive.

The extent to which the company can persuade the markets that the new fundswill be invested profitably will also have some bearing on the need for anunderwriter. If the company has a viable project then the share price could risein response to that information and that will make the issue even moreattractive. The company should discuss the likely market perception of theproject with independent experts such as the company’s merchant bankers.

This question was reasonably well answered by candidates

13 An associate company is one in which the holding company has an interest whichgrants it some influence, but not outright control. This is normally implied by aninvestment which exceeds 20% of share capital, but is less than 50%.

Associate companies are included in the consolidated profit and loss account byincluding the group’s share of their profits, regardless of whether those profitshave been distributed by way of dividend. The group share of net assets isincluded in the consolidated balance sheet.

The first part of this question was well answered however candidates had littleidea of how the associate should be treated in the consolidation as a result themarks were low.


Page 4

14 Many figures in the financial statements are difficult to interpret in isolation. Forexample, it means very little to know how much profit a business made withouthaving some corresponding idea of the amount of capital that had to be investedin order to generate this income.

Ratios provide a basis for comparing related figures and for identifying issuesthat ought to be investigated. Management might, for example, monitor liquidityby calculating the current ratio and would deal with any deviation from theoptimal relationship – usually 2:1.

Trends in ratios can be particularly revealing. For example, a decreasing currentratio is normally a more worrying sign than a ratio which appears to be low inabsolute terms.

Ratios do have a number of drawbacks. For example, they can be distorted bywilful manipulation of the figures (e.g. window dressing or off-balance sheetfinancing). They can also omit crucial information such as contingent liabilityinformation.

This question was well answered

15 If the company purchases the assets then it will receive a writing downallowance on both the industrial buildings and the plant and machinery. Thismeans that the tax benefits of the investment will not be received immediatelyafter the investment takes place. Instead, the company will have to offset thecost against taxable profit in future years.

If the company borrows in order to finance the acquisition of the assets then itwill be able to claim tax on the interest payments.

Rental payments on property and lease payments on plant and machinery willattract immediate tax relief, with the taxable profit being reduced by theamounts of the cash flow in each year.

The company’s ability to enjoy the tax relief on writing down allowances isrelated to its ability to earn taxable profits. If the company is making a loss fortax purposes then it will receive no benefit from the additional writing downallowances. A lessor may be in a better position to take advantage of these reliefsand this may well be reflected in the rentals.

This question was quite well answered by the majority of candidates.


Page 5

16 Merchant banks specialise in corporate finance. Their role is largely advisory.Typically, merchant banks will provide advice on the following types of matter:

1. bid or defence strategies in a takeover2. financial aspects of a merger3. investment projects4. raising capital

They also act as intermediaries in the issue of financial instruments:

1. issuing houses in share issues2. underwriters of new issues3. Eurobonds

Merchant banks also provide fund management services:

1. management of unit trusts, investment trusts and pension funds2. organisation of the Eurobond market

Merchant banks are active in the money markets:

1. as guarantors of bills of exchange2. as holders of Treasury bills and local authority bills

Occasionally, merchant banks provide finance to companies.

Candidates answered the first part of the question well but were unsure ofmerchant banks influence on the market.

17 The Bank of England acts in a supporting role for the various institutions thatare active in the short-term money markets, particularly the discount houses.

The discount houses provide short term finance by borrowing cash surpluses thatmight be available for as little as a few days and lending for a slightly longerperiod. This difference in maturity between their assets and liabilities can leavethem exposed to the risk of being unable to repay their debts.

The risk of default is avoided because the Bank of England will always providethe discount houses with support whenever they need it. This can take thefollowing forms:

1. The Bank will always be prepared to purchase Treasury or local authoritybills or bills of exchange from the discount houses in order to help themthrough a cash crisis.

2. The Bank will act as a lender of last resort provided the discount housesdeposit bills as security.

3. The discount houses can sell a bill of exchange to the Bank andsimultaneously agree to repurchase it at a later date.


Page 6

This support is available because the discount houses are an important elementof the Bank’s mechanism for controlling short term interest rates. The discounthouses agree to buy the Treasury bills that the Bank sells at its weekly Treasurybill auctions.

This question was well answered by most candidates.


Page 7

18 Tyler plc

Profit and loss account

for the year ended 31 March 2000

£000 £000

Turnover

Cost of sales - 4,100

Gross profit

Distribution costs - 1,600

Administrative expenses - 800

- 2,400

Operating profit

Interest payable - 1,680

Taxation - 1,290

Dividend - 1,400

Retained profit for the year

Retained profit brought forward

Retained profit carried forward 2,510

Tyler plc

Balance sheet as at 31 March 2000

£000 £000

Tangible fixed assets (note 1) 32,000

Current assets

Stock 700

Trade debtors 1,300

2,000

Creditors: amounts due within one year

Bank overdraft - 700

Trade creditors - 600

Taxation - 1,290

Proposed dividend - 1,400

- 3,990

Net current liabilities - 1,990

30,010

Long term liabilities - 12,000

18,010

Share capital 12,000

Revaluation reserve 3,500

Profit and loss 2,510

18,010


Page 8

Note 1 Tangible fixed assets

FactoryMachinery

Total

£000 £000 £000

Cost at 31 March 1999 23,300 12,300 35,600

Additions - 2,700 2,700

Adjustment on revaluation 1,700 - 1,700

Cost at 31 March 2000 25,000 15,000 40,000

Depreciation at 31 March 1999 1,340 6,000 7,340

Charge for year 460 2,000 2,460

Adjustment on revaluation - 1,800 - - 1,800

Depreciation at 31 March 2000 - 8,000 8,000

Net book value at 31 March 2000 25,000 7,000 32,000

Net book value at 31 March 1999 21,960 6,300 28,260

Cost of sales

Factory running costs 1,200

Manufacturing wages 1,300

Materials consumed 1,600

4,100

This question was badly answered very few candidates produced a note forfixed assets and the formats were poor. Given that this is not one of the newtopics it was surprising how badly the question was answered.

19 (a) Required rate on the research project = 3+(8*.6) = 7.8%

Required rate on expansion = 3+(8*1.3) = 13.4%

(b) The total risk associated with an investment is not particularly importantin the context of a diversified portfolio. A significant proportion of the riskin most investments can be diversified away. In other words, factors suchas movements in exchange rates will have an adverse effect on someinvestments and a positive effect on others. The effect of investing in aportfolio is to reduce the overall volatility of the returns.

Risk can be separated into two components: systematic and unsystematic.Systematic risk is inherent in the political and economic environment andis common to all companies. For example, a change in energy prices willaffect all companies to some extent. Unsystematic risk is specific to thecompany. It encompasses a range of risks specific to the company such aschanges in market demand for its products, stability of industrialrelations, nature and location of its assets, and so on.


Page 9

Systematic risk cannot be diversified away because it arises from factorswhich will have an effect on all companies. Thus, an increase in interestrates or oil prices is likely to have an adverse effect on all companies andwill depress returns from the market as a whole. Unsystematic risk canbe diversified away and, provided the investment is held in a properlydiversified portfolio, it can therefore be ignored.

It is possible that a highly speculative investment will not be affected bygeneral market conditions to any great extent. That means that it will nothave a high systematic risk. The volatility will, therefore, be due tounsystematic factors that can be diversified away. That, in turn, suggeststhat the investment may require a very low return.

(c) Company directors are in a rather different position from shareholders. Ashareholder can hold a diversified portfolio of investments and can,therefore, reduce the risks associated with a particular investment. Adirector will probably have only one principal employer and will,therefore, be motivated more by total risk.

This different perspective might be evidenced by a tendency to invest inrelatively safe projects. This is because a disaster might be rathercatastrophic for the board even though it would have relatively littleimpact on the shareholders.

Alternatively the board might be inclined to seek diversification for thecompany even though the shareholders can diversify for themselves.Given that diversification will have the effect of distracting managementfrom the core activities of the business, the overall effect will not be in theshareholders’ interests.

(d) One approach is to use the company’s own beta coefficient. That is onlyrelevant, however, if the project is subject to the same risks as thecompany as a whole.

Another approach is to use the beta of a company which is engaged in thesame line of business as the project.

A third possibility is to use historical data to estimate the betas ofindividual divisions or segments of the main company. These betas canthen be used as a surrogate for the coefficients of individual projectswhich fall within their scope.

This question was very badly done by most candidates. Many candidatescorrectly calculated the answer to part (a) and then demonstrated littleunderstanding of the theory required in the rest of the question. This is animportant area of finance and candidates should study the topic morecarefully.


EXAMINATIONS

14 September 2000 (pm)




1. Write your surname in full, the initials of your other names and yourCandidate’s Number on the front of the answer booklet.


3. Attempt all 18 questions, beginning your answer to each question on aseparate sheet.





Faculty of Actuaries108—S2000 Institute of Actuaries

108—2

For questions 1–4 indicate in your answer booklet which one of the answers A, B, C or Dis correct.

1 Which of the following statements is incorrect:

A Companies can issue ordinary shares below the par value.

B Ordinary shares normally offer a higher expected return than otherclasses of security.

C A company’s authorised share capital will be laid down in itsMemorandum of Association.

D An appropriate way of valuing ordinary shares is to find the present valueof the future dividend stream. [2]

2 One of G plc's employees developed a new product. This has just been patented.The development costs of this product were negligible, but the patent rights arealmost certainly worth many millions of pounds. Which accounting conceptwould prevent the company from recognising the value of this patent as a fixedasset in its balance sheet?

A Going concernB MaterialityC Money measurementD Prudence [2]

3 Which of the following is not true for a finance lease?

A The lease agreement has a primary period which covers all or most of theuseful economic life of the asset.

B The lessee is normally responsible for servicing and maintenance of theasset.

C The lease payments will appear in the profit and loss account as anexpense.

D The lessee records the leased asset as a fixed asset in its balance sheet.[2]

4 Which of the following best describes the effects of an increase in the riskcharacteristics of a project when evaluating its net present value?

A The discount rate increases and the net present value increases.B The discount rate increases and the net present value decreases.C The discount rate remains constant, but the net present value decreases.D The discount rate decreases and the net present value decreases.

[2]


In questions 5–10 one or more of the options may be correct. Answer in your booklet byselecting according to the following code:

A if I and II only are correctB if II and III only are correctC if I only is correctD if III only is correct

5 Companies who wish to raise finance by issuing sterling commercial paper haveto meet certain minimum standards. They must:

I be listed on the London Stock ExchangeII have a minimum level of net assets of £50mIII have a minimum level of share capital of £50m [2]

6 When choosing between two mutually exclusive projects, the internal rate ofreturn can give a misleading decision. Which of the following may be reasons forthis?

I Projects can have more than one rate of return.

II Internal rate of return ignores the rates of return available from otherprojects.

III Internal rate of return ignores the cost of capital. [2]

7 An increase in the value of a fixed asset due to revaluation would:

I increase the equity of a companyII make the balance sheet look strongerIII increase the profit of a company [2]

8 Which of the following would you normally expect to find in the external auditor’sreport to the shareholders:

I a certificate guaranteeing the truth and fairness of the financialstatements

II a statement that the directors were responsible for preparing the financialstatements

III a brief description of the work undertaken by the auditor prior to draftingthe report [2]

108—4

9 A company might carry out a rights issue at a deep discount:

I to reduce the share premium accountII to avoid misunderstandings by unsophisticated shareholdersIII to avoid having to pay underwriting costs [2]

10 Which of the following statements is true?

I Specific risk can be diversified away on a large, well spread portfolio.

II Systematic risk arises because of the volatility of the market as a whole.

III Diversification across a well diversified internationally-based portfolio willremove systematic risk entirely. [2]

11 Explain the shareholder value approach to project evaluation. [6]

12 X Plc is planning an expansion and requires £500,000 in order to do so. Thedirectors are unsure whether to finance this by debt or equity. Discuss thefactors they should take into account including any taxation implications. [8]

13 Describe the accounting standard setting process in the UK and explain whysuch a system is necessary. [8]

14 Describe the role life insurance offices play in the investment markets. [6]

15 Explain the taxation treatment of UK company dividends and also how frankedinvestment income is treated. [6]

16 Companies throughout the world raise finance by issuing Eurobonds. Describethe main characteristics of Eurobonds and briefly explain their popularity. [6]


17 The profit and loss accounts and balance sheets of two manufacturing companiesare shown below:

T Plc Y Plc£000 £000 £000 £000

Sales 600 700

Cost of sales 240 210

Gross profit 360 490

Selling expenses 54 84

Administrative expenses 60 35

114 119

Net profit 246 371

Taxation 64 100

182 271

Dividend 80 110

102 161

Retained profit b/fwd 106 230

208 391

T Plc Y Plc£000 £000 £000 £000

Fixed assets

Property - 500

Machinery 760 280

760 780

Current assets

Stock 48 26

Debtors 150 105

Bank 2 22

200 153

Current liabilities

Creditors (including Tax) 89 118

Net current assets 111 35

871 815

Share capital 663 424

Profit and loss 208 391

871 815

Compare these two companies in terms of their profitability and solvency.Explain which company appears to be the better managed in respect of each ofthese matters. You should support your answer with ratios. [20]

108—6

18 Z plc is a large, long established manufacturing company. The company isexpanding and the directors are keen to identify new ways in which they mightobtain the necessary finance. The finance director has warned that the companymust obtain most of this new funding from the sale of new shares. The companyhas borrowed very heavily in the past and the company's existing loanagreements require it to seek the permission of existing lenders before obtainingfurther debt.

Z plc is not quoted on the stock exchange. The family of the company’s foundersowns most of the company’s share capital. It is unlikely that these investors willbe able to invest the sums required to take advantage of the opportunities thatthe directors have identified. It has been suggested that the company might seeka stock exchange quotation.

(i) Explain the advantages and disadvantages to Z plc of issuing fresh sharecapital. [6]

(ii) Explain the advantages and disadvantages of obtaining a stock exchangequotation. [6]

(iii) Assuming that Z plc obtains a quotation, identify the most appropriatemethod by which the company might issue fresh share capital anddescribe the steps that are involved. Your answer should explain why youhave chosen this particular method. [8]

[Total 20]


EXAMINATIONS

September 2000


EXAMINERS’ REPORT

Faculty of ActuariesInstitute of Actuaries

Subject 108 (Finance and Financial Reporting) — September 2000 — Examiners’ Report

Page 2

1 A2 C3 C4 B5 A6 C7 A8 B9 D10 A

Comment on Questions 1 to 10

There were no particular problems with the objective test questions, with most candidatesscoring a reasonable mark.

11 The shareholder value approach to project evaluation considers the net presentvalue of the project from the shareholder’s perspective.

In theory, investing in a positive NPV project will increase shareholders’ wealthby the amount of that NPV. In practice, this change will only occur if the marketis aware of the investment and agrees with management’s estimates of thepotential risks and rewards. It may be that the share price will not move in linewith expectations because the market is not convinced that the risk is justified oreven because the directors have withheld important information for the sake ofcommercial sensitivity.

The directors would essentially attempt to apply the same valuation models usedby outside analysts and advisers in an attempt to determine how theinformation that they intend to publish will impact the share price.

Comment on Question 11

Many candidates had clearly not understood that the shareholder value approach is aclearly defined technique for project evaluation. A large number of answers were clearlybased on a sensible guess as to what the technique might comprise.

12 The directors should consider the current level of gearing. If the company isalready heavily financed by debt then it will be difficult for the directors to justifyborrowing more.

The use of one form of finance can have implications for the risks, and thereforecosts, associated with the other. Issuing fresh debt will expose the existingshareholders to a greater risk of losing their investment if the company is forcedto default on its loans. This will mean that the cost of equity might increase.Issuing fresh equity creates a broader “buffer” between assets and liabilities forproviding lenders with collateral and that might reduce the cost of debt.


Page 3

Debt finance is usually cheaper than equity and so the company should considerusing it wherever possible. The lower cost is partly because the debt holders aretaking much less of a risk when they purchase debt stock and are, therefore,willing to accept a lower rate of return.

The cost of debt is further reduced because interest is allowable as an expense fortax purposes, whereas dividends on shares is not.

It might be difficult to sell £500,000 of share capital without incurringdisproportionate issue costs. Raising debt can be rather more flexible. Thecompany could, however, get round this by issuing rather more than £500,000and using the additional sum raised to repay some of its existing debt.


This question was generally answered well.

13 A body called the Financial Reporting Council (FRC) is responsible for thestandard setting process. The FRC concentrates on the management of theprocess and delegates the real work of developing standards to the AccountingStandards Board (ASB). The FRC’s contribution to the process is largelyrestricted to raising finance for the ASB and appointing its members.

The ASB develops documents called Financial Reporting Standards (FRSs).FRSs are intended to reduce the number of acceptable treatments for specificitems in the financial statements. One example of this is FRS 2 which deals withgroup accounts. This standard defines the relationship between holdingcompanies and their subsidiaries and establishes a standard approach to theirincorporation into consolidated financial statements.

A typical standard would be set in the following manner:

• ASB establishes a working party.• Working party drafts an exposure draft (ED).• ED published and comments invited.• Interested parties may ‘lobby’ in defence of their interests.• There may be one or more rounds of revision to the ED.• FRS issued.

This process involves considerable openness, but it also creates the risk of thestandards being influenced by the actions of lobbyists.

This system is necessary because there have been many controversies over thecorrect preparation of financial statements. These have led to problems with thecredibility of the profession. Standards also reduce processing and interpretationcosts for users because they can become more familiar with the specifictreatments adopted by all companies for particular items.


Page 4


Many candidates appeared to be writing everything that they knew about accounting inthe hope that this related to the question. The most common error was to write a detailedexplanation of the concepts underlying financial accounting, with no reference whatsoeverto the regulatory framework referred to in the question.

14 Life insurance companies are major institutional investors and, collectively, areamongst the very largest institutions.

The companies collect cash from policy holders and invest this in the long term.Policy holders will normally be offered the expectation of a future bonus based onthe profits of the company. This has the effect of requiring insurance companiesto seek out investment opportunities which both offer the prospect of maintainingthe real purchasing power of their deposits and also a realistic expectation ofcapital growth.

Insurance companies are also subject to a number of regulatory constraints onthe nature of their investments. These are partly attributable to the need tomaintain solvency margins in accordance with DTI regulations.



15 Franked investment income (FII) is the grossed-up value of dividends paid by UKcompanies. The cash value of the dividend received is grossed up by the additionof a tax credit which is currently 10%.

The tax credit is a reflection of the fact that the dividend has been paid out ofprofits which have already been subject to corporation tax. Individuals who arebasic rate taxpayers will not normally pay any further tax on their FII. The FIIis added to their taxable income, but the tax credit will cancel the additional taxthat this would involve. Non taxpayers cannot, however, recover the tax creditwhich has been notionally withheld by the company. Higher rate taxpayers mayhave to pay some additional tax in order to satisfy their obligation to pay tax atthe higher rate.

Companies must also include their FII in their tax computation and will be liableto tax on it. This income will, however, be taxed at a flat rate of 20% regardlessof the rate of corporation tax to which the company is subject.




Page 5

16 Eurobonds are bonds which are issued outside of the company’s domicile. Thereis a thriving market in such arrangements. The fact that the stocks are tradedin a country in which the host government has no particular interest can meanthat they are not subject to any legal or tax regulations. This lack of regulationcan reduce issuing costs and the possibility of freedom from taxes can evenreduce the coupon rates of debts. Eurobonds tend to be traded through banksrather than recognised stock exchanges.

Eurobonds can be issued in almost any currency. They are redeemed at par withcoupon payments throughout the term of the bond. Almost all Eurobonds areunsecured. Eurobonds are bearer documents.

Most Eurobonds offer a fixed coupon rate, although some offer a variable couponrate.



17

T plc Y plc

ROCE 246 28 % 371 46 %

871 815

Gross profit % 360 60 % 490 70 %

600 700

Selling / sales 54 9 % 84 12 %

600 700

Admin / sales 60 10 % 35 5 %

600 700

Current ratio 200 2.2 :1 153 1.3 :1

89 118

Acid test ratio 152 1.7 :1 127 1.1 :1

89 118

Y plc is the more profitable company because it has a higher return on capitalemployed. It appears to have achieved a higher return by virtue of three factors:

• It can generate a higher gross profit from every £ of sales. Either it is sellingat a higher margin or it can obtain goods at a lower cost price.


Page 6

• Its sales appear to be supported by a higher spend on advertising. This hasenabled it to achieve higher sales despite having higher selling prices.

• It manages to spend less on administration.

Y plc also appears to have better managed working capital. At first glance, T plchas a “textbook” current ratio of 2:1. The company has a very high acid testratio, which appears to be due to very slow turnover of debtors. This means thatthe company has a great deal of finance tied up in non-productive assets. Theseare not necessarily available to meet short-term commitments.



18 (i) Share capital is the most flexible form of finance. The payment ofdividend is entirely at the discretion of the directors. If the dividends arewithheld for any reason then the shareholders have no direct sanctionsagainst the company, other than the right to sell their shares on the openmarket.

Issuing fresh share capital also makes it easier to raise further finance byborrowing. This is because lenders are usually keen to see the companymaintain a sensible relationship between debt and equity. If the companyfails then the lenders must be repaid in full before the shareholdersreceive anything. If the shareholders have financed a large proportion ofthe share capital then this protects the lenders from the loss of theirprincipal.

Share capital tends to be a rather expensive form of finance. This isbecause shareholders bear a much higher risk than lenders. They have tobe rewarded with a substantial return in order to motivate them to acceptthis level of risk. In addition, the company does not receive any tax reliefon dividends whereas loan interest is tax deductible.

Issuing additional share capital will also tend to dilute the sense ofownership and control enjoyed by the present shareholders. They mightbe willing to forego the opportunity to expand if doing so would makethem accountable to outside shareholders.

(ii) A stock exchange quotation would provide a ready market for the sale ofshares. This would make it easier for the company to sell fresh shares onthe open market. It would also offer existing and future shareholders ameans of disposing of their shares.

The fact that an investment in the company could be liquidated moreeasily would make it a more attractive prospect, thereby reducing the costof finance.


Page 7

The availability of a ready market means that market forces willdetermine an objective share price. This can be a useful piece ofinformation for shareholders and directors alike. There can be taxproblems associated with the gift of shares that cannot be easily valued.Knowing the share price makes it easier to calculate the cost of capital.

The stock exchange imposes strict regulations on the behaviour of quotedcompanies. The fact that a company is willing to accept this disciplineprovides further confidence for both shareholders and lenders and soshould have the effect of further reducing finance costs.

There are, of course, substantial transaction costs associated withobtaining a listing. Apart from professional fees and other direct costs, agreat deal of management time will be taken up.

The fact that the company’s shareholders can sell their shares easily onthe market might encourage them to take a short-term outlook. Thiscould make the company vulnerable to take-over bids.

(iii) The company ought to consider an offer for sale. This would involveselling new shares to the general public at a fixed price which wasdetermined by the directors. The advantage of this is that it raisesadditional capital at the same time as introducing the company to thestock exchange.

There is relatively little risk of this type of transaction going wrongbecause the company would sell the shares via an issuing house. Theissuing house would act as an intermediary between the company and thepublic. In the first instance, the issuing house would purchase the sharesfrom the company and then resell them to the public. This means thatthe company knows in advance how much the issue will generate becausethe issuing house is responsible for any lack of demand and will be leftholding any unsold shares.

The use of an issuing house also provides the company with a source ofexperience and advice in the selection of other professionals and in thecoordination of their various efforts.

Well before the offer for sale, the company will engage an issuing house.The issuing house will try to generate interest in the launch, e.g. bypublicising positive news that might be picked up by the financial press.

In the weeks before the launch, the issuing house will advise on the pricethat should be set. This will normally be a reasonably conservativefigure, if only because a higher issue price would involve a greater risk forthe issuing house and that might result in higher fees and premia.

The company is required to publish a prospectus, which is a formaldocument required by the stock exchange. This is a detailed documentcontaining a wealth of historical and forecast information, both financialand non-financial. This information will also be supported by a number of


Page 8

assurances from the company’s external auditors. The prospectus willalso state the offer price for the shares.

The prospectus will be reproduced in at least one national newspaper andmay be distributed in other ways.

Anyone wishing to purchase shares can do so during the periodimmediately after the publication of the prospectus. Hopefully, the offerprice was set at a level that would encourage investment and the issuewill be over-subscribed. This means that the issuing house will have todecide on the most appropriate basis for the allocation of shares.

Finally, the successful applicants will receive letters of acceptance.Official trading on the stock exchange can take place on the day after theacceptance letters are posted.


This question tended to be answered well in some parts, but not others. Parts (i) and (ii)were generally answered well, although there was very little attempt to relate answers tothe facts of the scenario. Part (iii) tended to generate a checklist of mechanisms for issuingshares instead of recommending one particular technique, as required by the question.


EXAMINATIONS

5 April 2001 (pm)

Subject 108 ó Finance and Financial Reporting



1. Write your surname in full, the initials of your other names and yourCandidateís Number on the front of the answer booklet.


3. Attempt all 18 questions. From question 11 onwards begin each answer on aseparate sheet.





! Faculty of Actuaries108óA2001 ! Institute of Actuaries

108 A2001ó2

For questions 1ñ10 indicate in your answer booklet which one of the answers A, B, C or Dis correct.

1 C plc is to make a 3 for 5 rights issue at 120p. If the price of the shares on theday the allotment letters were posted was 140p, what price would you expect forthe shares ex-rights when dealings commence?

A 127.5pB 130pC 132.5pD 140p [2]

2 A key difference between the net present value technique and the internal rate ofreturn technique for capital budgeting is:

A that the net present value is easier to calculateB that they use different cash flowsC that they have different reinvestment rate assumptionsD that they are relevant to the shareholders [2]

3 Which of the following would NOT be included in a firmís capital structure?

A retained earningsB dividendsC capital surplusD convertible debentures [2]

4 Which of the following is NOT a current asset?

A stockB creditorsC debtorsD cash [2]

5 Which of the following is NOT a method of short term borrowing?

A commercial paperB bill of exchangeC factoringD leasing [2]

108 A2001ó3 PLEASE TURN OVER

6 Which of the following are limited companies NOT required to produce as aresult of the Companies Act?

A chairmanís reportB directorsí reportC balance sheetD auditorís report [2]

7 Which of the following is NOT a method of bringing a security to listing?

A an offer for saleB a scrip issueC an offer for subscriptionD an introduction [2]

8 A manufacturing companyís cash balances have run low. Which of the followingwould increase cash in the short term?

A press debtors for prompter paymentB pay creditors more quicklyC encourage sales staff to sell moreD delay the acquisition of a piece of manufacturing equipment [2]

9 Which of the following statements is NOT true of self-administered pensionfunds?

A a typical fund invests mainly in index linked giltsB most existing schemes are defined benefit schemesC all the schemes are responsible for their own investment strategyD almost all private sector schemes are funded [2]

10 Which of the following is NOT an intangible asset?

A development costsB patentsC investmentsD goodwill [2]

11 Explain the differences between an investment trust and a unit trust. [8]

12 Explain why a company would seek a Stock Exchange quotation. [8]

108 A2001ó4

13 Describe the different reports the external auditor can give when it is impossibleto express an unqualified opinion. [6]

14 Ordinary shares are the most important form of financial instrument used by UKcompanies.

(i) Describe the main characteristics of ordinary shares. [6]

(ii) Explain why ordinary shares are more marketable than loan capital. [2][Total 8]

15 Explain why pension funds have special regulations governing the form andcontent of their financial statements. [4]

16 Explain why a company might issue convertible securities instead ofstraightforward debt or equity. [6]

17 PQR plc is a pharmaceutical company. The companyís research department hasidentified a compound that can cure the common cold without any side effects.Unfortunately, the manufacture of this compound requires the company to investheavily in a high technology factory which will use a number of new techniques,some of which are unproven. The company will also need to recruit and retainthe services of a number of eminent scientists, each of whom is both vital to theproject and would be irreplaceable.

Financing this project will require the company to borrow heavily. The companyis unlikely to survive as an independent entity if it invests in this project and itfails. The directors have been advised that there is at least a 50% chance of acatastrophic failure.

The project has a beta of 0.5. The risk free rate is 3% and the equity riskpremium is 8%. The project offers an estimated return of 24%.

REQUIRED:

(a) Calculate the required rate of return for the project. [2]

(b) Explain how investing in this project would affect the wealth of PQR plcísshareholders. [5]

(c) Explain how an apparently risky project can have a relatively lowrequired rate of return. [7]

(d) Explain whether you believe that the directors of PQR plc will invest inthe project. [6]

[Total 20]

108 A2001ó5

18 MNO plc has a number of different business interests. The directors of MNO areinterested in identifying managers for promotion to senior positions. As part ofthis process, they are comparing the performance of two autonomous divisions,both of which purchase goods in bulk for resale to small retailers. Each divisionis responsible for a different part of the country, but is otherwise engaged in thesame line of business. The directors have prepared the following summaryfinancial statements from the companyís bookkeeping records:

Easterndivision

Westerndivision

Profit statements (year ended 31 December 2000) £000 £000

Sales 800 1,400 Cost of sales 320 490 Gross profit 480 910 Advertising and distribution 80 196 Administration 64 56 Operating profit 336 658 Interest 24 11 Net profit 312 647

Balance sheets (as at 31 December 2000) £000 £000

Fixed assets 1,000 1,200

Current assets Stock 51 57 Debtors 80 222 Bank 10 7

141 286 Current liabilities

Creditors 48 53 Working capital 93 233

Long term loans 200 100 893 1,333

Capital 893 1,333

(a) Compare the performance of the two divisions in terms of theirprofitability, liquidity and management of stock, debtors and creditors.Your answer should be supported by relevant ratios, although theseshould form only part of your analysis. [14]

(b) Describe the limitations of your analysis in (a), explaining why thedirectors should seek additional information before making a finaldecision about the suitability of either divisional management team forpromotion. [6]

[Total 20]


EXAMINATIONS

April 2001


EXAMINERSí REPORT


Subject 108 (Finance and Financial Reporting) ó April 2001 ó Examinersí Report

Page 2

Suggested answers:

1 C

2 A

3 B

4 B

5 D

6 A

7 B

8 A

9 A

10 C

Generally all Multiple Choice Questions were answered correctly with the majority ofcandidates scoring over 16.

11 Investment trusts are companies, most of which are listed on the StockExchange. Shares in investment trusts can be purchased and sold as for anyother quoted company.

Unit trusts are not companies, but are trusts in the strict legal sense. They cannot,therefore, be quoted on the Stock Exchange. Units can only be bought from and sold tothe management company which organises the trust.Investment trusts tend to specialise in investments in other companies, althoughsome invest in gilts, property and overseas companies.Unit trusts are far more heavily constrained and regulated in terms of what theycan invest in and they tend to restrict their investments to quoted securities.Investment trusts can borrow in addition to raising funds from investors. Unittrusts must rely on the sale of units for finance. This means that investmenttrusts can offer their shareholders the benefits of gearing whereas unit trustscannot.

Units in unit trusts are normally priced by taking the market value of the trustísunderlying assets and dividing by the number of units. The management chargesapplied for running the fund are paid for by an initial charge levied on the fundinvested. Shares in investment trusts are normally worth less than the marketvalue of the assets divided by the number of shares. The main reason for this is


Page 3

that the managers take an annual fee for their management charge and this hasthe effect of depressing the value of the shares relative to their underlying assets.

This question was answered very well with most candidates scoring very highmarks

12 A quotation will help to raise capital. If the company is quoted then it will be able tosell shares to a wide market and raise large sums cheaply. This is because thequotation will provide a free secondary market in the companyís shares.Providers of debt will lend more happily to a quoted company as they know that thecompany must comply with the Stock Exchange requirements on an ongoing basis.Shareholders will also benefit from the fact that the shares will have a readilyobservable market price which may be useful for tax purposes and also for portfoliomanagement. These advantages will also help the company to raise funds.The ease with which shares in quoted companies can be traded means thatshareholders have an easy exit route if they ever decide to sell their investment.The fact that they can do so means that they will feel far more secure when buyingshares.The ready availability of a market price means that the shares are far moreacceptable to employees if they are granted as part of a share option scheme. It willbe possible to attribute a value to the shares or options received.The fact that the shares are listed will also make them more readily available touse as the purchase consideration in a takeover situation. Shareholders of thetarget company will have a far clearer impression of the relative values of theshares being offered compared with the ones that they already hold.

Excellent answers by many candidates. Candidates who had studied the corereading found this question straightforward.

13 The most common form of qualified opinion is the ìexcept forî form. This isappropriate when the auditor has encountered a material disagreement over thefinancial statements or has been subject to a material uncertainty because thescope of the audit work has been restricted. The except for makes it clear that thefinancial statements give a true and fair view ìexcept forî the changes that wouldhave been necessary in order to correct for the disagreement or in response to theresolution of the uncertainty.

There are two more extreme forms of qualified opinion. Adverse opinions are usedwhen the auditor disagrees with the impression created by the financial statementsso violently that s/he is of the opinion that the financial statements do not give atrue and fair view. Disclaimers of opinion are given when the auditor is faced withsuch fundamental uncertainty that it is impossible to tell whether the financialstatements give a true and fair view. In this latter case, the auditor refuses toexpress an opinion.

In each of the cases described above, the auditor will describe the problems thathave led to the need for a qualified opinion and will make their implications clear


Page 4

to the readers. Then the report will clearly state the opinion, making use of one ofthe prescribed forms of qualification.

This question was the most poorly answered in the paper, clearly most candidateshad ignored this in the core reading. I would emphasis that all topics in the corereading are likely to be examined and it really pays to study all the areas.

14 Ordinary shareholders bear the risks and rewards of ownership. They are last tobe repaid in the event that the company fails. They may also receive little or nodividend at difficult times. On the other hand, they will also be entitled to all ofthe profits after tax and any preference dividend. They will normally be the onlyones entitled to vote at general meetings.

Ordinary shareholders will normally have a relatively volatile return from theirinvestment, but this will be compensated for by the possibility of unrestrictedopportunity for capital growth. If the company is a massive success then the shareholdersmay find that their stake increases in value beyond all recognition.

Ordinary shares are backed by real trading assets. This means that they offer ameasure of protection against inflation. This is reflected by the fact that, onaverage, ordinary shares have given a higher long term return than any otherinvestment.

Ordinary shares are normally irredeemable. Indeed, there are provisions that aredesigned to ensure that shareholders cannot have their capital returned.

Shareholders normally receive a dividend, although the amount of this will be atthe discretion of the directors. The amounts will be affected by the companyísperformance and also by the boardís desire to retain funds for future expansion.Ordinary shares tend to be marketable because there is an active secondarymarket in the shares of quoted companies. This is assisted by the fact that theshares tend to be issued in large, homogenous blocks, making the creation of amarket worthwhile. Other instruments are more likely to be issued in smaller,more fragmented tranches and so there is less scope for offering a liquidsecondary market.

Again answered well.

15 Pension funds offer a vehicle for investment, in exactly the same manner as anyother form of commercial entity. There are, however, significant features whichmakes their accounting principles different:

• Pensioners have far less scope for diversification in their pensions than in anyother type of investing activity. This means that they have to be keptinformed about the stewardship of their fund to reduce the risk of them beingleft exposed to the loss of their pensions.


Page 5

• Pension funds have very long term commitments to pensioners and mustdemonstrate that they are being managed for the long term.

• The loss of a pension may be far more serious than the loss of any other typeof investment. Pensioners may be far more vulnerable because they areunlikely to have the capacity to earn sufficient income to make up for anyloss.

These factors come together to create a need for members of a pension fund toreceive adequate accounting information to enable them to measure thestewardship and performance of the fund. The readers may be relativelyunsophisticated and require even greater protection than that offered to the readersof the financial statements of limited companies.

Most points mentioned by candidates , however little mention of accountinginformation in most answers.

16 Convertibles are attractive to issuers when it is felt that the price of the ordinaryshares is abnormally low. This might happen in the case of a start-up or a businesswhich is dealing with considerable temporary uncertainty. Issuing fresh sharesunder such circumstances would dilute the equity of existing shareholders. Therewill still be some dilution when the debentures are converted, but this willhopefully be less than would arise if the shares had been issued when the companywas at a transitional stage.

The company has to be reasonably confident that the share price is onlytemporarily depressed, otherwise the debenture holders would not convert. Inthat case the company would have to find cash in order to meet the redemption.Convertibles are essentially a means of raising equity during difficult periods. Theycan be preferable to straight loan stock because they are self-liquidating and can beissued at a slightly lower coupon rate. They might attract a particular group ofinvestors who are looking for a guaranteed short term income plus the possibility ofa capital gain at a later date.

This question was poorly answered, many candidates described convertibles butwere at a loss to suggest why companies might wish to issue them. It would bebeneficial if candidates could apply the core reading to different situations ratherthan simply memorising facts.

17 (a) The required rate of return is risk free rate + (beta x equity risk premium).Required rate of return = 3% + (0.5 x 8%) = 7%.

(b) Investing in this project would increase the shareholdersí wealth. Therequired rate of return, taking risk into account, is only 7%. The projectactually offers 24%. This means that the project has a positive net presentvalue (NPV) and the value of their shares will increase by the NPV of thisproject.The increase will, however, only occur if the stock market has sufficientinformation to form a view on its likely outcome. It must also agree withmanagementís evaluation of the project. If shareholders are less optimisticthan the board then the share price will not rise by as much.


Page 6

(c) The risks associate with investments are split into those that can bediversified away and those that cannot. The risks that can be diversifiedaway can be ignored because any rational investor will hold a broad portfolioof assets. Some of the investments will do badly but this will be compensatedby the fact that others will do well. Over the portfolio as a whole the investorshould expect to have a return that tends towards that offered by themarket as a whole.

If the portfolio has been well constructed, the only variation from marketreturns should be because of any deliberate structuring of the portfolio toleave the shareholder exposed to more or less of the risks faced by themarket as a whole. These risks cannot ever be diversified away because theyaffect all companies to some extent or another. For example, an increase ininterest rates will push down most share prices to some extent and so allinvestments will suffer.

Looking at PQR plcís project from the shareholdersí perspective, many of therisks are very specific to the investment. The risk that the technology willnot work or that the staff will leave can be countered by investing in asufficient spread of other securities to cancel the highs and lows on thisproject with those obtained from others. The project might not beparticularly sensitive to factors that affect the market as a whole and so itneed not require a high rate of return.

(d) In theory the directors should only be concerned with the shareholdersíwealth. That means that they should invest in this project because it has apositive NPV. The fact that it might threaten the companyís existence wouldnot matter because their portfolios will include some companies that will failand others that will thrive.

The directors cannot, however, diversify in quite the same manner. Most oftheir income will come from this one company and their personalreputations will be associated with its success or failure. They will,therefore, have a great deal to lose if they put the shareholdersí interestsfirst. The directors might also feel a moral responsibility towards the otheremployees to ensure that the company survives in order to keep them inemployment.

The directors might also be concerned that many investors will notappreciate the importance of planning their investments on a portfolio basis.They might criticise the directors for taking a risk that is, in fact, justified bythe returns offered. If they do not accept that many of the risks are specificto the project and can be diversified away they might accuse the directors ofmismanagement.

Part a was well answered , the remaining parts of the question were poorlyanswered, most candidates had learned facts but found it difficult to applythese to practical situations.


Page 7

18 (a)Eastern Western

Return on capital employed 312+24893+200

31 % 647+111333+100

46 %

Profit margin 336800

42% 6581,400

47%

Gross profit % 480800

60 % 9101400

65 %

Advertising I sales 80800

10% 1961400

14%

Administration / sales 64800

8% 561400

4%

Asset turnover 8001000

0.8 times 14001200

1.2 times

Current ratio 14148

2.9 times 28653

5.4 times

Quick ratio 141 ñ5148

1.9 times 286-5753

4.3 times

Stock turnover 51 x365 320

58 days 57 x 365 490

42 days

Debtors turnover 80800

37 days 2221400

58 days

Creditors turnover 48320

55 days 53490

39 days

Western has a higher return on capital employed. That is enough in itself toindicate that it is the more profitable of the two companies.Western appears to have spent more on advertising with a view to seeking ahigher selling price per unit. This may have contributed to a higher overallprofitability. The company has also managed to save considerably onadministration costs, spending only 4% of turnover as opposed to 8%. Finally,Western has managed to obtain a higher asset turnover.Western has also managed liquidity more effectively. The company has leanercurrent and quick asset ratios. Eastern appears to be heavily over invested inunproductive assets.Finally, Western also appears to have a better strategy for the management ofstock, debtors and creditors. It is turning stock over rapidly, thereby managingcash flows. It has managed to offer debtors a reasonable period of credit, possiblyjustifying its premium pricing policy. It is also paying creditors within a realisticperiod, thereby maintaining its credit rating.

(b)There is always a risk that accounting figures are not comparable. Theaccounting policies could be different or the companiesí accountants could havemade different estimates and assumptions.Western is also 50% larger in terms of turnover. That might make the companyappear to be more efficient, when it is actually enjoying economies of scale. Theseeconomies could mask an underlying weakness in management.There could be other structural reasons why Western enjoys greater success. Thecompany could, for example, sell to a different, more profitable market segment.Barriers to entry might make it impossible for Eastern to compete directly.

Well answered by most candidates.


EXAMINATIONS





1. Write your surname in full, the initials of your other names and yourCandidateís Number on the front of the answer booklet.


3. Attempt all 19 questions. From question 11 onwards begin each answer on aseparate sheet.





! Faculty of Actuaries108óS2001 (15.2.01) ! Institute of Actuaries

108 S2001ó2

For questions 1ñ10 indicate in your answer booklet which one of the answers A, B, C or Dis correct.

1 Which of the following is subject to taxation in the UK?

A social security benefitsB winnings from gamblingC profits from an ISAD dividends from a UK company [2]

2 Which of the following statements is NOT true of investment trusts?

A an investment trust is a companyB they raise equity and debt capitalC they never invest in the shares of other UK companiesD most investment trusts are listed on the stock exchange [2]

3 When a firm announces a two-for-one scrip issue investors should expect that, (inthe absence of other new information):

A earnings per share will fall but the stock price will remain the sameB the stock price will fall but the earnings per share will remain the sameC both the earnings per share and the stock price will remain the sameD both the earnings per share and the stock price will fall [2]

4 The nominal value of a bond is received by the bondholder:

A at the time of purchaseB annuallyC whenever coupon payments are madeD at maturity [2]

5 The net present value method of capital budgeting assumes that cash flows arereinvested at:

A the firmís cost of capitalB the firmís dividend yieldC no rate ó they are not reinvestedD the rate of return of the project [2]

108 S2001ó3 PLEASE TURN OVER

6 The payback method can lead to the wrong decision being made because:

A it ignores income beyond the payback periodB the payback period is difficult to calculateC the returns in later years are uncertainD of the emphasis placed on the interest factor [2]

7 Which of the following changes in working capital will result in an improvementin a companyís net cash inflow from operating activities?

A increase in creditorsB increase in stockC increase in debtorsD decrease in other current liabilities [2]

8 The following ratios were calculated from the financial statements of G plc, amajor manufacturing company.

Stock turnover 12 daysDebtors turnover 42 daysCreditors turnover 46 days

For how long, on average, does G plc have cash tied up in any particular piece ofstock?

A 8 daysB 12 daysC 54 daysD 100 days [2]

108 S2001ó4

9 H plcís summary financial statements are as follows:

Profit and loss accountFor the year ended 31 March 2001 £000

Profit before tax and interest 2,000Interest (300)Taxation (500)

1,200Dividend (700)Retained for year 500Balance brought forward 4,700Balance carried forward 5,200

Balance sheetAs at 31 March 2001 £000

Total assets less current liabilities 35,200Long term loans (3,000)

32,200

Share capital 27,000Profit and loss account 5,200

32,200

Calculate H plcís return on capital employed.

A 3.7%B 4.3%C 5.7%D 7.4% [2]

10 Which of the following statements is NOT true of double taxation relief (DTR)?

A The UK has a double taxation agreement with many countries.

B The maximum offset is the rate of tax that would have been paid in theUK.

C DTR is available on revenue of a capital nature.

D DTR is only available on income received from abroad. [2]

11 Explain why the net present value criterion is superior to other methods ofinvestment appraisal. [6]


12 Explain the influence of a central bank (e.g. the Bank of England) on thegovernment bond market. [6]

13 Explain how a companyís capital structure might influence its share price. [6]

14 Describe the role building societies play in investment markets. [4]

15 Discuss the interests of four user groups of financial statements and explain whysome of the groupsí interests may conflict. [8]

16 Explain how a companyís UK corporation tax liability is calculated and when itmust be paid. [6]

17 Describe the factors that must be determined when selecting a companyísdepreciation policy. [4]

18 D plc is in the process of making a 1 for 4 rights issue. The rights letters havejust been sent to shareholders. The company currently has 20m £1 shares inissue and the current market price is £4.50 per share.

The rights letter gives shareholders the right to buy their new shares for £3.50each. D plc plans to use the cash raised to build a major extension to its factory,thereby doubling production capacity.

The finance director has received an angry letter from a shareholder. Theshareholder complains that he cannot afford to invest in new shares. He is,therefore, likely to suffer a loss because the fact that the market will be floodedwith cheap shares will almost certainly decrease the value of his holding.

Required:

(a) Calculate the value at which the share price is likely to settle after therights issue. [2]

(b) Explain whether the shareholder's complaint is justified with particularreference to the difference between the rights price and the currentmarket price. [4]

(c) Explain whether the share price is likely to settle at the figure calculatedin (a) above. [4]

(d) Discuss the advantages and disadvantages of financing the extension byissuing loan stock. [5]

(e) Discuss the advantages and disadvantages of financing with a commercialmortgage. [5]

[Total 20]

108 S2001ó6

19 The following information has been extracted from the bookkeeping records of Zplc:

Z plc

Trial Balance as at 30 June 2001.

£000 £000 Administrative expenses 25 Advertising 200 Bank 6 Creditors 54 Debtors 140 Interest 120 Land and Buildings ó cost 983 Land and Buildings ó depreciation 45 Loan 600 Manufacturing overheads 35 Plant and Machinery ó cost 550 Plant and Machinery ó depreciation 150 Profit and loss as at 1 July 2000 180 Purchases 450 Sales 1,200 Share capital 200 Share premium 300 Stock as at 1 July 2000 18 Wages ó administrative staff 44 Wages ó distribution staff 30 Wages ó manufacturing 140

2,735 2,735

Notes:

(i) Closing stock was counted at the year end and was valued at £19,000.

(ii) Depreciation is to be charged on the following bases:

Factory ó 2% of costPlant and Machinery ó 25% of reducing balance

(iii) The directors have decided to pay a dividend of £80,000 for the year.

(iv) The corporation tax charge has been estimated at £22,000 for the year.

(a) Prepare Z plcís profit and loss account for the year ended 30 June2001 and its balance sheet as at that date. These should be in aform suitable for publication insofar as this is possible from theinformation provided. [15]

(b) Comment on any notable features of Z plcís dividend policy, asrevealed by your answer to (a) above. [5]

[Total 20]


EXAMINATIONS

September 2001


EXAMINERSí REPORT


Subject 108 (Finance and Financial Reporting) ó September 2001 ó Examinersí Report

Page 2

Examinerís Comments

Questions 1 to 10There were no particular problems with the objective test questions, with mostcandidates scoring a reasonable mark.

Question 11The only recurring problem with this question was a slight failure to answer thequestion. Many candidates described the shortcomings of various methods withoutexplaining whether they had been dealt with by net present value.

Question 12


Question 13

Many candidates wrote very general essays about gearing and its calculation ratherthan discussions of how gearing might affect share price.

Question 14


Question 15

Again, marks were lost because of a failure to answer the question as set. Mostcandidates managed to discuss the information needs of various users groups, but manyeither ignored the further requirement to explain how those information needs mightconflict or discussed the different business strategies and policies that each group mightprefer to see the company adopt.

Question 16

This question was answered reasonably well, although a significant minority ofcandidates focussed on capital gains and indexation allowance rather than addressingthe whole question.

Question 17

Most candidates scored well on this question, although many answers tended to describedepreciation and identified the points required by the question almost by chance.

Question 18

This question was generally answered well, although many candidates seemed to beunaware that shareholders could sell their rights rather than letting them lapseunexercised. Others appeared to expect the share price to stabilise on the theoreticalprice without any consideration for the possibility that market expectations concerningthe use of the funds raised might have a role to play.


Page 3

Question 19

Most candidates managed to produce reasonable accounting statements and scored well.Most candidates also spotted that the company had a relatively optimistic dividendpolicy relative to its profitability.


Page 4

1 D

2 C

3 D

4 D

5 C

6 A

7 A

8 A

9 C

10 C

11 Net present value takes account of the time value of money. This gives it animmediate advantage over several other methods such as payback andaccounting rate of return. These do not take into account the effects of interestrates and also ignore some cash flows.

Net present value gives a direct link to the effect of the project on theshareholdersí wealth. Other methods, such as IRR, can indicate whether aproject would increase their wealth, but would not indicate by how much.

Net present value is the only criterion that reliably ranks mutually exclusiveprojects.

12 The Bank licences gilt-edged market makers and imposes certain requirementson them in return for which they receive certain privileges.

Market makers can buy, sell or borrow gilts direct from the bank and they getfavourable tax treatment.

The bank is responsible for keeping the main register of owners of gilts.

The bank buys and sells gilts. It uses various methods of selling gilts: offers forsubscription, auctions, tenders, tap stocks and taplets. The bank buys gilts inthe market weeks and months before maturity so it does not have to find billionsof pounds on one day.


Page 5

The bankís activities have the effect of providing liquidity throughout themarkets and thereby enable government to influence liquidity and thereby shortterm interest rates.

13 Capital structure, or gearing, can affect the profits available to the shareholders.Debt is a relatively cheap source of finance. If the company borrows rather thanissuing further share capital then a larger proportion of the returns from theresulting investments will be available to the shareholders. The company canalso claim tax relief on the interest and that will further decrease the cost ofdebt.

Debt can also affect the volatility of returns to shareholders. Interest and capitalrepayments must be paid regardless of whether the company has had a good yearor not. The fact that this fixed commitment must be met means that thecompany may have very little profit left for the shareholders in leaner years.Conversely, the fixed return offered to the lenders will mean that any upturn inrevenues will lead to all of the excess being passed on to the shareholders. Thismeans that borrowing will accentuate any fluctuations in the operating profit.

14 Building societies take deposits and invest mainly in mortgages for housepurchase. They do, however, find themselves with surplus cash and will investthis in short dated gilts and local authority bonds and in other banks andbuilding societies.

This means that building societies have some, but not much, influence in themarkets for short dated gilts and local authority bonds.

Building societies also raise funds by issuing long term debt capital. This is inthe form of index-linked bonds and so they have considerable influence in thismarket.

15 Equity investors make investment decisions and require information aboutprofits and cash flows. Analysts are constantly preparing and updating forecastsof performance. The annual report provides an opportunity to ìfine tuneî theseforecasts. Existing shareholders also require information about the transactionsauthorised by the directors for stewardship purposes.

Loan creditors make lending decisions involving the measurement of the risk ofdefault. A lender wants to know whether a business can generate sufficient cashto repay any loan. The lender will also wish to ensure that the business has anadequate asset base to meet its obligations in the event of failure. To this end,loan agreements often contain restrictive covenants which are based onaccounting numbers.

Employees are interested in the enterpriseís ability to pay salaries and also tooffer job security. Accounting information is, however, of limited value for suchdecisions.


Page 6

Business contacts are interested in continuity of sales (to customers) and ofmaterials and services (from the suppliers). Their interest is, therefore, similarto that of the shareholders. They may also use accounting information to try togain some insight into the companyís pricing and trading policies.

These groups have different needs and it may be that better serving the needs ofone will conflict with the others. For example, investors require the mostrealistic impression possible of the companyís performance. Lenders will prefer amore conservative treatment so that they can better manage the risk of default.

16 Companies are liable to corporation tax on their taxable profits. Taxable profitsinclude income less expenses and capital gains. The tax year runs for 12 monthsto 31st March regardless of the companyís financial year.

Corporation tax is paid 9 months after the end of the accounting period except forìlargeî companies who pay tax on a current year basis by quarterly instalments.

The accounting profit is adjusted to arrive at the taxable profit. The mainadjustments are: add back any business expenses shown in the accounts whichare not allowable, add back any depreciation and deduct gross frankedinvestment income and subtract capital allowances.

17 The depreciation charge is affected by the estimated useful life of the asset,taking account of the possibility that it might be replaced before it reaches theend of its physical capacity. It will also be affected by the estimated residualvalue of the asset when it reaches the end of its useful life. These requiresubjective decisions, particularly with respect to useful life because this is themost important single factor in determining the charge in any one year.

The other factor that can affect depreciation is the allocation of the loss of valueto the different accounting periods. Depreciation can be written off in equalinstalments (straight line) or on other bases (e.g. reducing balance). The choiceof method can also have a significant effect on the charge in any one year.


Page 7

18 (a) Before the rights issue, four shares would have been worth 4 ! £4.50 =£18.00. In theory, after the issue, this would leave five shares worth£18.00 + £3.50 = £21.50.

Thus, the shares would be worth £4.30 each.

(b) There is no reason why the shareholder should either have to buy newshares or suffer any loss in wealth. He must, however, either take up hisrights or sell them for their market value. Provided he takes one of thesesteps, the issue should have no effect on his wealth. The larger thediscount, the more valuable the rights to subscribe.

It would be worth pointing out that the discount is necessary to avoid thecompany having to pay substantial underwriting fees. If the rights pricewas close to market value then the share price could increase so that itwas cheaper to buy shares on the open market than to take up the rights.The discount actually helps to ensure that the issue proceeds smoothlyand without undue expense. It is, therefore, in the shareholdersíinterests, whether they choose to take up their rights or sell them.

(c) It is impossible to tell what the share price will actually be after the issue.Everything depends on the marketís perception of the companyís future.If the markets are aware of the detailed purpose of the issue and if it isconfident that management has a viable project then the share price couldbe far higher than the theoretical ex-rights price. If the market is unsureabout the company s prospects then the share price could actually fallmuch further than our prediction.

(d) Loan stock is a cheaper form of finance than equity.

Issuing loan stock will involve substantial costs.

The fresh loan stock will increase gearing, reducing the companyísborrowing future capacity and increasing the risks associated withexisting debt and equity.

The loan stock holders will rank alongside the existing lenders forpayment and may require a higher rate of interest to compensate for this.

It may be difficult to organise an issue quickly in order to get theextension work under way.

(e) The mortgage will be even cheaper than the loan stock because the loanwill be secured against the new property.

It should be possible to organise the mortgage reasonably quickly.Even though the loan is secured against a specific asset that will bebought out of the proceeds of the loan it will still reduce the companyísfuture borrowing capacity.The costs of negotiating and organising the mortgage will be lower thanfor the issue of loan stock.


Page 8

The mortgage holder might insist on restrictive covenants which willreduce the companyís freedom to enter into contracts in the future.

19 (a)

Z plcProfit and Loss Accountfor the year ended 30 June 2001

£000 £000 Sales 1,200.0 Cost of sales ñ743.7 Gross profit 456.3 Administration ñ69.0 Distribution ñ230.0

ñ299.0 Operating profit 157.3 Interest ñ120.0 Net profit before taxation 37.3 Taxation ñ22.0

15.3 Dividend ñ80.0

ñ64.7 Balance brought forward 180.0

115.3


Page 9

Z plc Balance Sheet as at 30 June 2001

£000 £000Fixed Assets

1,218.3

Current Assets Stock 19.0 Debtors 140.0

159.0

Current liabilities Bank ñ6.0 Proposed dividend ñ80.0 Taxation ñ22.0 Creditors ñ54.0

ñ162.0 Net current liabilities ñ3.0

1,215.3 Loan ñ600.0

615.3

Capital and reserves Share capital 200.0 Share premium 300.0 Profit and loss account 115.3

615.3


Page 10

Note ó Fixed AssetsCost Aggregate

depreciationNet book

value

£ £ £ Factory 983.0 ñ64.7 918.3 Machinery 550.0 ñ250.0 300.0

1,533.0 ñ314.7 1,218.3

Workings Cost of sales Opening stock 18.0 Purchases 450.0 Closing stock ñ19.0 Factory ó depn

19.7 Machinery ó depn 100.0 Manufacturing overhead 35.0 Manufacturing wages 140.0

743.7

Admin expenses 25.0 Admin wages 44.0

69.0

Distribution Advertising 200.0 Wages 30.0

230.0

(b) The companyís dividend exceeds its profit for the year. This means thatthe dividend has been financed by drawing on retained profits fromprevious years. That is perfectly legal, although it does tend to suggestthat Z plc is determined to maintain its dividends regardless of whether ithas had a good year or not.

It is also noticeable that the company has a bank overdraft and has verylittle in the way of working capital. This means that the company willhave to borrow, perhaps substantially, in order to meet the commitmentrepresented by the dividend payment.

It may be that the companyís shareholders have put the directors undersome pressure to maintain their dividend. It may be that the directors donot have sufficient confidence in the shareholdersí judgement to riskpaying a more realistic dividend relative to the profit for the year.


EXAMINATIONS

12 April 2002 (pm)




1. Enter all the candidate and examination details as requested on the front of your answerbooklet.

2. You must not start writing your answers in the booklet until instructed to do so by thesupervisor.


4. Attempt all 19 questions. From question 11 onwards begin each answer on a separatesheet.



Hand in BOTH your answer booklet, with any additional sheets firmly attached, and thisquestion paper.

In addition to this paper you should have available Actuarial Tables andyour own electronic calculator.


108 A2002ó2

For questions 1ñ10 indicate in your answer booklet which one of the answers A, B, C or D iscorrect.

1 Which of the following roles would NOT typically be played by a merchant bank?

A acting as a trusteeB large scale lending to corporate borrowersC issuing treasury billsD providing advice on company mergers [2]

2 Which of the following bodies is primarily responsible for issuing accountingstandards in the UK?

A Financial Reporting CouncilB Accounting Standards BoardC Accounting Standards CommitteeD Urgent Issues Task Force [2]

3 Which of the following statements is NOT true of companies issuing commercialpaper?

A They must be listed on the London Stock Exchange.

B They must issue a statement that they comply with the requirements of theStock Exchange.

C They must have a minimum level of net assets of £50m.

D They must have the commercial paper endorsed by a merchant bank. [2]

4 Which of the following best describes the manner in which individuals can claim taxrelief for capital losses?

A Capital losses can be offset against capital gains in the same year. Any unusedcapital loss may be carried forward to offset against capital gains in the nextthree years.

B Capital losses can be offset against capital gains in the same year. Any unusedcapital loss may be carried forward to offset against capital gains in any futureyear or years.

C Capital losses can be offset against capital gains in the same year. Any unusedcapital loss may be offset against taxable income in that year.

D Capital losses can be offset against capital gains in the same year. Any unusedcapital loss may be carried back to reclaim tax paid on capital gains during theprevious three years. [2]


5 Which of the following is most likely to be true:

A A companyís cost of equity will be equal to its weighted average cost ofcapital.

B A companyís cost of equity will be greater than its weighted average cost ofcapital.

C A companyís cost of equity will be lower than its weighted average cost ofcapital.

D A companyís cost of equity will fluctuate around its weighted average cost ofcapital. [2]

6 Which of the following types of company is most likely to employ a high proportionof equity financing?

A supermarketB property companyC IT developerD bank [2]

7 Which of the following statements is NOT true of factoring.

A A factoring service may be with recourse or without recourse.

B Factoring is the sale of debts to a factor at a discount.

C Factoring companies often provide their clients with bookkeeping services tosave them from keeping their own records of debtor balances.

D The factor will make payment to the client as soon as the debt is collected.[2]

8 Which of the following statements is NOT true?

A Companies can issue ordinary shares below the par value.

B The expected overall future return for ordinary shares ought to be higher thanfor most other classes of security.

C The Memorandum of Association will set out the total nominal value ofauthorised share capital.

D An appropriate way of valuing ordinary shares is to calculate the present valueof the future dividend stream.

[2]

108 A2002ó4

9 In certain circumstances the Stock Exchange may grant a quotation for a companyeven though the company is not making any new shares or existing shares available tothe market. This method of obtaining a quotation is known as:

A a placingB a prospectus issueC a tender issueD an introduction [2]

10 Which of the following changes in working capital will result in an outflow of cash?

A decrease in creditorsB decrease in stockC decrease in debtorsD increase in other current liabilities [2]

11 One of R plcís shareholders has written to the directors to complain that the companyhas reduced its dividend payment compared to last year. The shareholder is of theopinion that this action has reduced his wealth.

Identify the matters that should be included in the directorsí reply to their unhappyshareholder. [5]

12 Outline the key features of the taxation of a life insurance company. [6]

13 Explain how a holding company would construct a set of consolidated financialstatements. [6]

14 Explain how you would price units in a unit trust, including a consideration ofwhether the fund is expanding or contracting. [5]

15 Trade credit and debt factoring are both used to provide business with short termfinance. Outline the main features of each, stating the advantages and disadvantagesof each. [6]

16 Accountants are guided by a series of accounting concepts when they preparefinancial statements. Identify any three such concepts and explain how each affectsthe content of the financial statements. [6]


17 A company operates several successful restaurants. It is considering franchising itsrestaurant concept in a scheme whereby the company and the franchisee would investequal amounts in setting up each new restaurant. The company would then receive apercentage of the turnover from each restaurant for the life of the agreement.

Outline how simulation might be used to estimate the cash flows from each proposedfranchise site. [6]

18 The directors of Y plc are concerned that the company has a relatively low return oncapital employed. They have asked you to help them to identify the areas where thereis the greatest need for improvement. You have asked your assistant to obtain thefinancial statements of Y plcís most successful competitor and to compare these withthose of Y plc. Your assistant has prepared the following table of ratios:

Y plc Competitor

(a) Return on capital employed 8% 15%(b) Turnover / Fixed assets 4:1 6.5:1(c) Current ratio 3:1 1.8:1(d) Gross profit percentage* 27% 34%

* Both companies sell very similar product ranges. Their market is very competitiveand their selling prices are almost identical.

(i) Explain why each of the ratios (b) to (d) above help us to understand why Yplcís return on capital employed is relatively poor. [6]

(ii) For each of the ratios (b) to (d) above, recommend courses of action tomanagement which would improve Y plcís return on capital employed. [9]

(iii) Explain why the limitations of financial reporting could mean that thecomparison of Y plcís performance with its competitor might provemisleading. [5]

[Total 20]

108 A2002ó6

19 W plc was established nine years ago. The company has grown steadily throughoutthat period and the directors are beginning to plan the next stage of expansion. Thecompany requires to raise a substantial amount of finance in order to grow and thedirectors are considering the options that are open to them.

One possibility is to raise funds through borrowing. Another would be to raise furtherequity, although the directors are of the opinion that they might have to seek a stockexchange quotation in order to do so.

(i) Describe the tax implications of selecting a source of finance from the point ofview of the company and the provider of the finance. [5]

(ii) Explain why it might not always be appropriate for management to choose theleast expensive form of capital whenever new finance is required. [5]

(iii) Explain the advantages and disadvantages of seeking a stock exchange listing.[6]

(iv) All of W plcís shares are held by the directors, all of whom are activelyinvolved in the running of the company. Describe one advantage and onedisadvantage of having a ìtightî shareholding. [4]

[Total 20]


REPORT OF THE BOARD OF EXAMINERS ONTHE EXAMINATIONS HELD IN

April 2002


Introduction

The attached subject report has been written by the Principal Examiner with the aim ofhelping candidates. The questions and comments are based around Core Reading as theinterpretation of the syllabus to which the examiners are working. They have howevergiven credit for any alternative approach or interpretation which they consider to bereasonable.

K FormanChairman of the Board of Examiners

11 June 2002! Faculty of Actuaries

! Institute of Actuaries


Page 2

1 C

2 B

3 D

4 B

5 B

6 C

7 D

8 A

9 D

10 A

Generally questions 1-10 were well answered, most candidates scored well. There was noparticular question which was badly done.

11 If the company does not have sufficient cash to pay a dividend or if it does not havesufficient retained profits to fund one then the directors would be both irresponsibleand in breach of company law if they were to pay one. Paying a dividend under suchcircumstances could also damage the companyís cash flows at a sensitive time andmight actually reduce the value of the shareholderís investment by far more than theamount of dividend received.

The directors might also decide to suspend or reduce a dividend in order to providefunds for investment. Doing so will often avoid the issue costs associated with sellingshares and the transaction costs associated with borrowing. If the markets anticipatethat this expansion will be successful then the share price will increase by at least theamount of the dividend foregone. In that case, the shareholderís wealth will actuallyhave improved because of the companyís decision to reduce dividends. If theshareholder was relying on cash from the dividends then he or she could sell someshares in order to realise part of the capital gain.

Unexpected variations in dividend policy could worry the market and so it would beundesirable for the directors to have reduced the payments without prior warning.

This question was answered well by most candidates. It was designed to test knowledge of theissues associated with the dividend decision. Most candidates demonstrated goodunderstanding.


Page 3

12 A life insurance companyís activities are split into various different funds accordingto the type of policy. The two most important funds are:

(1) the pensions business fund(2) the life business and general annuity business fund

The two funds are taxed in a different way. Income, capital gains and expenses areattributed to each class of business separately. Expenses in one class of business arenot allowed to offset tax in another class.

Pensions business is taxed on a profits basis. Profits are calculated as:

Premiums received+ investment income+ capital gains! payments made to policyholders! pension fund expenses! increase in reserves needed to meet future payments to policyholders= taxable profits

The life business and general annuity business is taxed on a different basis:

Investment income+ realised capital gains! life business expenses! general annuity business expenses! income element of general annuity payments to policyholders= taxable profits

This question was well done by many candidates, there were however a number of candidateswho scored very poor marks. Some candidates appeared to be familiar with the material in thecore reading on this topic while others were not.

13 The first step is to identify the subsidiary companies. These are essentially thecompanies over which the holding company can exercise control.

The holding company should ensure that the accounting policies used throughout thegroup are consistent.

Any transactions and balances between group members must be identified so that theycan be excluded from the consolidation.

The figures in the financial statements are combined to give the group totals forturnover, expenses, assets and so on. However, any inter company elements areexcluded from the consolidation so that sales would include only sales to third partiesoutside of the group and so on.


Page 4

The process of cancelling internal balances extends to the holding companyísinvestment in the subsidiaries. These will be cancelled against the related obligationsfrom the subsidiaries to the holding company as represented by the equity as at thedate of acquisition. Any balancing figure arising because of differences between thecost of the investment and related equity is called goodwill and is written off againstretained profit.

Any equity in subsidiaries held by third parties should be shown on the consolidatedbalance sheet as a minority interest.

This question tested awareness of the important accounting topic of preparation ofgroup financial statements. Most candidates appeared comfortable with this material.

14 The price of the units is calculated by the managers to be:

Market value of assetsNumber of units

Unit trust managers must use this formula, but they have some discretion over thecalculation of the ìmarket value of assetsî. They can use the cost of buying newassets (ìoffer pricingî) or the cost of destroying units (ìbid pricingî).

The managers can change from offer to bid pricing, depending on circumstances.Offer pricing is used when the unit trust is expanding and bid pricing is used when itis contracting.

This question required awareness of the broader issues associated with the valuation ofunits. Candidates were generally well prepared for this.

15 Trade credit is the short term finance offered by vendors. Much trade is done on thebasis that all goods will be supplied on credit and paid for at an agreed time, often 30days after receipt. It is necessary to establish a credit facility with each vendor,although this is usually a relatively simple process. The vendor will usually request acredit reference and may carry out background checks with a credit agency.

Trade credit is usually a fairly flexible form of finance, although the cost is not alwaysimmediately obvious. The purchase prices will include an element for finance. Manyvendors will impose additional interest penalties in case of overdue amounts and thismay also lead to a report being passed to a credit agency, thereby reducing thecompanyís score.

Debt factoring is also a source of short term finance. It is essentially a loan securedon the companyís debtorsí balances. Once the company has reached an agreementwith the factor, it will send copies of invoices on despatch of goods. The factor willthen pay an agreed proportion of the invoice by return. The debtor will normallymake payment to the factor and this will lead to the factor making a second paymentof the balance from the invoice, less interest.


Page 5

There are two types of factoring. Non-recourse factoring is where the supplier takesover all responsibility for credit analysis of new accounts, payments collection, andcredit losses. Recourse factoring only provides early payment of invoices, with creditrisk remaining with the original supplier.

This question tested the candidatesí knowledge of different form of medium termfinance. The candidates answered this question very well, with many achievingexcellent marks.

16 The cost concept ó requires that assets appear in the balance sheet at their originalcost, less any depreciation to date. Effectively, it is assumed that the purchasingpower of money will remain unchanged. While this is clearly invalid, it simplifies thetask of maintaining bookkeeping records. The disadvantage is that accountingstatements frequently report totals which are made up of inconsistent units.

The money measurement concept ó accounting statements restrict themselves tomatters which can be measured objectively in money terms. Again, this simplifiesaccounting enormously. It also means that a balance sheet will rarely give even arough approximation of the value of the business because it will exclude such items asthe values of the companyís customer base, its work force and its brand names.

The going concern concept ó it is usually assumed that a business will continueindefinitely in its present form. This concept acts as a justification for the limitationsimposed by the cost concept because there is little harm in reporting irrelevant figuresfor value if the assets concerned are unlikely to be sold in the immediate future.

The business entity concept ó the affairs of the business are kept separate fromthose of the owners. This is perfectly valid in the case of a limited company, whichhas its own legal identity. It would, however, also apply to sole traders andpartnerships where the business does not exist except as part of the ownersí estate.

The realisation concept ó states that income is recognised as and when it isìearnedî. It is not, therefore, necessary to wait until the customer settles his or herbill. This avoids the fluctuations in reported income which might arise if everythingwas accounted for on a cash basis. It can also create the impression that the businessis performing well when, in fact, it is in danger of running out of cash. A businesswhich is expanding might report income long before the related cash inflows.

The accruals concept ó expenses are recognised as and when they are incurred,regardless of whether or not the amount has been paid. Again, this avoids the randomallocation of costs to periods depending on whether the bill happens to have been paidor not.

Prudence ó the preparers of the financial statements should avoid presenting anunduly optimistic set of results. Thus, the lowest reasonable figure should be statedfor profit or for any of the assets. The highest reasonable figure should be stated forany liabilities. This means that there is very little danger of the figures lullinganybody into a false sense of security by overstating the companyís strengths.


Page 6

Consistency ó the figures published by the company should be comparable from oneyear to the next. Accounting policies should not, therefore, be changed from one yearto the next unless there is a very good reason for doing so. Any changes should behighlighted and their impact explained.

Materiality ó there is little point in providing information which is so detailed as tobe unintelligible. The statements can, therefore, be made clearer by showing totalssuch as ìadministrative expensesî instead of listing every item which makes up thisheading. Similarly, there is very little point in making minute adjustments whichhave no real effect on the picture portrayed by the financial statements. Thusaccountants might report rough approximations for certain costs rather than wastetime calculating more precise figures.

Candidates were good at identifying the concepts but were weaker when it came todiscussing how the concepts might affect the financial statements. This resulted inpoor marks for this question. This demonstrates the need to think carefully aboutaccounting issues - candidates with good understanding of the concepts scoredhighly.

17 The first step would be to develop some model that can be used to estimate turnoverunder various conditions. The company could try to identify the factors that appear toaffect the turnover in its existing branches. These could include factors such as thedistance to the nearest competitor, the number of people passing the branch at certaintimes of day, proximity to any major concentrations of customers (e.g. a majorrailway station) and so on. The company could then combine these factors in anattempt to model turnover for the existing shops for comparison with historical data.

The models could then be applied to potential franchise locations. These should bemodelled many times using variations of the underlying assumptions in order toestablish whether the forecasts appear to be robust. This could be done bydetermining probability distributions for factors such as passing trade and thelikelihood of fresh competition.

This question was not answered by a number of candidates, and there were many weakanswers from the candidates who did attempt the question. The question required someapplication of the issues covered in the core reading although this did not require aninordinate level of understanding. The best way to tackle such a question would be to imaginedealing with the problem in the real world.

18 (i) The ratio of turnover to fixed assets measures the companyís ability togenerate sales from its fixed asset base. Y plc cannot match the productivityof its competitor and is, therefore, bringing in a smaller return from itsinvestment in fixed assets.

Capital tied up in current assets generates little or no direct return. Yíscompetitor has less invested in these unproductive assets. This means that Yhas either had to divert capital from more productive activities or that thecompany has borrowed more in order to finance working capital.


Page 7

The gross profit percentage is a measure of the companyís ability to generateprofits from any given sale. Given the nature of the market, Yís competitorappears to be selling similar products at similar prices, but generating a higherprofit on every sale. Even if the companies were equally efficient in their useof assets, this would enable the competitor to enjoy a higher ROCE. The factthat the competitor also manages to generate more sales from every £ of itsasset base means that it has a double advantage over Y.

(ii) The company should review its utilisation of fixed assets. It may be that thereis scope for reorganising the company so that it can improve its output. Giventhe ìbenchmarkî provided by the competitor, it looks as if there is scope formaking greater use of them. The reasons for not doing so should be identified.It may be possible to accomplish a great deal from a simple reorganisation. Ymay have to make some further investment if the investigation reveals thatthere is a bottleneck which constrains the use of the existing assets.Alternatively, the review may indicate that the company has spare capacity, inwhich case it should consider either diversifying into another area in order tomake use of the slack or it should sell any surplus assets.

Y plc should review its activity ratios: stock, debtor and creditor turnover. Ifstocks or debtors are turning over too slowly then the reasons for this shouldbe established. It may be that the company will have to invest in bettersystems which enable it to exert a greater control over working capital. It maybe that staff simply need to be better trained or motivated in order to avoidwasteful investments in stock or sales ledger accounts. The company mightalso be able to pass some of the burden for financing working capital on tosuppliers. If the creditors turnover is too rapid then it may be able to delaypayments, thereby releasing some cash with which to finance expansion or toreduce capital employed. The company should also review its cash balances.While it is prudent to hold some cash, the company needs to make sure that itis not tying too much up in low yielding bank accounts.

Given that Y plcís selling prices cannot be increased without the loss of sales,the problem appears to be that it is paying too much for its product. This maybe because the company has not been aggressive enough in negotiating withits suppliers. It may be that there are less expensive suppliers or that thecompany could switch to a smaller number of suppliers so that it can obtainthe benefit of bulk discounts. The company may also be incurringunnecessary overheads (e.g. depreciation on unproductive assets) and thesecould be eating into the profit margins too.

(iii) The figures in the financial statements are highly subjective. The statementsproduced by the competitor could have been affected by greater optimism orpessimism on the part of the accountants who prepared them. This attitudecould have been due to a genuine difference of opinion or it could have beendue to the company being under some pressure to distort its figures in onedirection or another.

The figures might not be comparable for other reasons. For example, theassets of both companies could be shown at historical cost. The asset bases of


Page 8

both businesses might be identical, but the company with the older assets willhave the lower book value because of the effects of rising prices anddepreciation. This could have the effect of reducing return on capital.

The figures could have been affected by transactions occurring close to theyear end. For example, the purchase of new assets just before the year endwill increase capital employed, but the company will have had no opportunityto generate a return from this.

This question tested candidates understanding of accounting ratios. Manycandidates produced good answers demonstrating understanding of the topic.

19 (i) One of the main choices is between equity and debt. Debt is generally moretax efficient from the companyís point of view because interest is taxdeductible whereas dividends on equity is not.

Different forms of borrowing will have different cash flows and taximplications. For example, the purchase of an asset using borrowed moneywill attract tax relief on the interest and the company will also be able to claimcapital allowances on the price of the asset itself. The purchase of an assetusing a finance lease will attract tax relief on the whole of the lease payments,but the borrower will not be able to claim capital allowances.

The company should also consider the tax implications for the providers offinance. Their tax position will affect the cost of capital because they will beconcerned with their returns after tax. Shareholders might prefer equitybecause they can manage their exposure to tax by selecting the point at whichthey realise capital gains. Interest received from loans is, however, taxed as itis received and so there is less scope for management of tax.

(ii) It would be short-sighted to rely exclusively on the cheapest form of financefor every decision. This is partly because issuing fresh debt can affect theoverall risk characteristics of the companyís existing debt and equity. The riskof the company becoming forced into default increases as gearing rises.Issuing fresh debt might undermine confidence in the company as a whole andthat could lead to a disproportionate increase in the cost of capital.

The benefits of the tax allowances associated with debt are dependent on thecompany having sufficient profit to offset the interest against. The gross costof the debt might become more relevant if the company issues fresh debt whenit is breaking even or making a loss.

There can be substantial issue costs for some forms of finance. The fixedcosts associated with issuing shares can be so great that the company shouldnot consider raising finance in this way unless an economic amount is beingraised.


Page 9

(iii) The main advantage is that shares will be far more attractive to the capitalmarkets. Anyone buying shares will be able to sell them at any time and at areadily observable market price.

Existing shareholders will also enjoy the opportunity to sell some of theirshares and realise some of the gains earned during their period of ownership.They will also benefit from the fact that they will have a market price which isacceptable as a valuation basis for tax purposes.

The main disadvantage of a listing is one of cost. There are substantialprofessional fees and other expenses associated with obtaining a listing.

The stock exchange will also impose additional reporting and other regulatoryrequirements on the company.

Having a quotation will make it easier for outsiders to mount a takeover bid.This could prove a distraction for management, especially when the companyis vulnerable during difficult times.

(iv) The fact that the company is owned and managed by the same individualsavoids a host of problems associated with accountability and agency.Shareholders normally require some assurance that the directors are notpursuing their own interests.

There is no conflict between the interests of the owners and the managers andso there is less risk of dysfunctional behaviour on the part of the directors. Forexample, the directors will be under much less pressure to pursue short termprofits at the expense of longer term wealth.

The narrow shareholding makes it more difficult to raise fresh equity from theexisting shareholders. This will make it more expensive to raise additionalequity whenever the need arises.

The narrow shareholding will also make it more difficult to obtain a stockmarket quotation because of the regulations designed to ensure a free and openmarket.

The candidates answered part 1 very well as they could explain the differencesbetween funding by debt or equity.

Most candidates were aware of the advantages and disadvantages of Stock Exchangelisting but were not so good at part 4 which asked about tight and narrowshareholdings, this required application of the core reading and some candidatesfound this difficult. Again thinking of a practical example could be helpful.


EXAMINATIONS













! Faculty of Actuaries108óS2002 ! Institute of Actuaries

108 S2002ó2


The following information relates to questions 1 to 3:

Y plc is a quoted company. The following information has been extracted from thecompanyís annual report and other sources:

£mEarnings before interest and tax 36Interest 1.65Tax 9.9

Book values Market values£m £m

Share capital (£1 shares, fully paid) 40 178Debenture stock 15 19

1 Y plcís earnings per share figure is:

A £0.14B £0.61C £0.86D £0.90 [2]

2 The most relevant measure of Y plcís gearing for decision making purposes is:

A 7.8%B 9.6%C 27.3%D 32.2% [2]

3 If prevailing interest rates increase, what is likely to happen to the market prices ofY plcís financial instruments?

A Share price ! Debenture price !B Share price " Debenture price !C Share price " Debenture price "D Share price ! Debenture price " [2]

4 S plc has 20 million shares in issue, with a current market price of £5 a share. Arights issue will allow one share to be purchased for every five shares currently heldby shareholders for £3 each. Which of the following is true?

A The number of shares in issue will fall to 16 million.B The firm will raise £32 million.C The share price will fall to £4.67.D The total value of the company will decrease to £88 million. [2]


5 Which of the following would NOT affect an income tax calculation?

A contributions made to an approved pension schemeB benefits in kindC personal allowanceD income from an ISA [2]

6 Why might a scrip issue lead to an overall increase in a companyís marketcapitalisation?

A there are more shares in issue

B shareholders can sell their new shares without affecting their original holding

C scrip issues are only possible if the company has been profitable in past

D scrip issues are often interpreted as a sign of confidence on the part of thedirectors in the future performance of the company [2]

7 Which of the following will calculate a companyís taxable profit?

A accounting profit + capital allowances + depreciation+ franked investment income

B accounting profit " capital allowances " depreciation" franked investment income

C accounting profit " capital allowances + depreciation" franked investment income

D accounting profit + capital allowances " depreciation" franked investment income [2]

8 Building societies will normally NOT invest surplus cash in the following:

A Short dated giltsB Banks using certificates of depositC Ordinary sharesD Local authority bonds [2]

108 S2002ó4

9 Which of the following statements about gilt-edged market makers (GEMMs) is NOTtrue?

A The Bank of England licences GEMMs.

B Only the GEMMs can buy, sell or borrow existing gilts directly from the Bankof England.

C They are given no special tax treatment.

D Only the GEMMs can make a market in gilts. [2]

10 Which of the following is NOT a valid reason for using simulation in order toevaluate an investment project?

A the cash flows are uncertainB the required rate of return might vary during the life of the projectC decision makers are interested in the range of possible outcomesD decision makers require an accurate forecast [2]

11 Explain how the statement of net assets for a pension fund differs from the balancesheet of a company reporting under the requirements of the Companies Act. Outlinereasons for these differences. [5]

12 Describe the differences between a bank overdraft and a bank loan and indicate howeach might be used by a business. [6]

13 A company has been offered the following mutually exclusive investment projects:

Project 1 Project 2

Initial investment £400,000 £80,000Payback 6 years 3 yearsInternal rate of return 9% 13%Net present value £63,000 £10,500

(i) Explain why the three investment criteria ó payback, internal rate of return(IRR) and net present value (NPV) ó might have given different rankings forthe two projects. [3]

(ii) Explain which of the two projects is the optimal investment project for thecompany, based on the information given. [3]

[Total 6]


14 Most businesses of any size operate as a group of companies and these are required toprepare and publish consolidated financial statements.

(i) Explain why consolidated statements are preferable to having the statementsof each of the companies in the group. [4]

(ii) Identify TWO figures that you would expect to find in a consolidated balancesheet that would not normally appear in an individual companyís accounts.Explain what each of these figures reflects. [6]

[Total 10]

15 Harold and Maude are in the process of setting up a risk management consultancy.They have known each other for a relatively short time, but have decided to go intobusiness together. The initial setting up costs will be fairly substantial: the businesswill need to pay a deposit on a leased office and will have to purchase computers andother office equipment. Maude has agreed that she will fund most of these from hersavings, with Harold providing roughly 10%. Harold and Maude have agreed thatboth will work full-time in the business and that each will probably contribute equallyto the success and profitability of the enterprise.

(i) Explain the relative advantages and disadvantages of setting up this businessas a partnership and as a limited company. [4]

(ii) Assuming that Harold and Maude decide to incorporate the business as alimited company, describe the best way to organise their interests in terms ofMaudeís investment in the initial setting up and the equitable sharing of profitsand losses. [4]

[Total 8]

16 Explain the possible uses by a non-financial company of swaps. [5]

108 S2002ó6

17 The directors of D plc have decided to review their decision to invest £12 million innew equipment. They have decided that their initial decision to make this investmenthad not been adequately justified in terms of formal investment appraisal techniques.

In the past, the directors have appraised all investments by discounting the expectedcash flows at 9.5% per annum. This required rate of return is based on the interestrate likely to be charged by D plcís bank on a term loan. They have, however,recently decided that it would be more appropriate to relate the required rate of returnto the risk associated with the investment. They have decided to apply the CapitalAsset Pricing Model (CAPM) when appraising investment opportunities.

The directors have decided that the investment in the new equipment constitutes anexpansion of the company and that it would be appropriate to use the Beta coefficientof the company as a whole as a surrogate for the project Beta. The companyísstockbrokers have advised them that the company Beta is 0.6. The risk free rate is 3%and the risk premium is 8%.

(i) Calculate the required rate of return for the investment project using theCapital Asset Pricing Model (CAPM). [2]

(ii) Explain how a highly risky project, such as investment in a high technologyindustry, might have a relatively low required rate of return in the context of aportfolio of investments. [8]

(iii) Explain how the beta coefficient of a project might be estimated. [5]

(iv) Explain how the share price of a company quoted on the stock exchangeshould move in response to an investment in a project with a positive netpresent value. [5]

[Total 20]

108 S2002ó7

18 The following information has been extracted from the bookkeeping records of B plc:

B plc

Trial Balance as at 31 August 2002.

£000 £000

Administrative expenses 435 Bank 14 Cost of goods sold 800 Creditors 110 Debtors 240 Interest 110 Land and Buildings ó cost 2,300 Land and Buildings ó depreciation 180 Loan 1,400 Plant and Machinery ó cost 900 Plant and Machinery ó depreciation 350 Profit and loss as at 31 August 2001 180 Sales 2,600 Selling and distribution costs 850 Share capital 500 Share premium 400 Stock as at 31 August 2002 99

5,734 5,734Notes:

(1) Depreciation is to be charged on the following bases:Factory ó 3% of cost;Plant and Machinery ó 25% of reducing balance.

All depreciation is to be charged to the cost of sales.

(2) The directors have decided to pay a dividend of £150,000 for the year.

(3) The corporation tax charge has been estimated at £40,000 for the year.

(i) Prepare B plcís profit and loss account for the year ended 31 August 2002 andits balance sheet as at that date. These should be in a form suitable forpublication insofar as this is possible from the information provided. [14]

(ii) The directors of B plc are under some pressure to report a higher than normalprofit figure this year. It has been suggested that they might reduce thedepreciation charge by revising their estimate of the useful lives of fixedassets.

Explain whether it would be possible to restate profit by artificially depressingthe depreciation charge. [6]

[Total 20]


EXAMINATIONS

September 2002


EXAMINERSí REPORT

Introduction


K G FormanChairman of the Board of Examiners12 November 2002



Page 2

1 B

2 B

3 C

4 C

5 D

6 D

7 C

8 C

9 C

10 D

There were no particular problems with the objective test questions, with most candidatesscoring a reasonable mark.

11 The statement of net assets is similar to a balance sheet, but is simpler in that it merelylists the investments, cash balances, any other assets that the fund has and anyimmediate liabilities that it owes.

The statement of net assets does not show the long term liability due to the schemeísmembers. This is omitted because it is difficult to measure with any certainty andalso because it will not arise until some time in the distant future. Such considerationshave not, however, prevented liabilities from being disclosed in the financialstatements of limited companies.

The special regulations for pension funds arise because a pension is likely to be amajor component of any individualís wealth. Unlike stocks and shares, it is virtuallyimpossible to diversify oneís pension arrangements in order to spread the risk of badluck, fraud or mismanagement. Whereas a company can afford to plan for the short tomedium term future, a pension scheme has responsibilities to pensioners which mightnot crystallise until they retire in the distant future, when the fund must be in aposition to meet its commitments in full.

This question was designed to test basic understanding of one of the primary accountingstatements of a pension fund. This question was generally answered poorly, with manycandidates displaying little or no knowledge of the statement of net assets. Others made noattempt to compare the statement with the balance sheet of a limited company.


Page 3

12 A bank overdraft is a loan drawn against a facility offered by the bank. The bank willprovide the business with the ability to write cheques until the balance reaches apredetermined maximum. The company may have to pay for the overdraft facilityitself, but will pay interest only on the balance outstanding at any given time. Theoverdraft may remain outstanding for many years, but it is always repayable ondemand.A loan is a predetermined amount that will normally have to be repaid in accordancewith a prearranged schedule. The borrower will pay interest in accordance with theagreed basis specified in the loan agreement, but this will normally be a percentage ofthe capital balance outstanding.

Overdrafts tend to be an expensive source of finance. This means that it will usuallybe cheaper to take out a loan if the company needs cash for a specific length of time.An overdraft will be cheaper if the amount required varies throughout the loan periodand will also offer flexibility if the company runs short of cash.

This question was answered well, demonstrating awareness of two of the principal sources ofshort-term finance.

13 (i) The methods give different rankings because each stresses different criteria.Payback is concerned only with cash flows during the early part of the project.Internal rate of return is concerned only with the interest rate implicit in theproject. Net present value is concerned with the increase or decrease in wealthresulting from the project. A relatively short-term project could, therefore,favour payback. One with a high yield over a short period or on a small initialinvestment could favour IRR.

(ii) The company should choose project 1 because it has the higher net presentvalue. Project 1 will have the greatest positive impact on shareholder wealth.Project 2 is less attractive in the long term, although it does offer theopportunity of a higher rate in the short term if the company is faced withcapital rationing.

Many candidates failed to recognise that the primary consideration is the impact on theownersí wealth. That means that net present value will normally provide the correct rankingof mutually exclusive projects. Many answers consisted of little more than a regurgitation ofthe points raised in the core reading with respect to the different investment criteria.

14 (i) Consolidated statements are necessary because the individual companystatements will usually include a mixture of balances and transactionsinvolving fellow group members as well as third parties. This will make itdifficult, if not impossible, to get any real indication of the overall size of thegroup or the extent of its operations. Even if there was no real interactionwithin the group, it will be far easier and more convenient to work with thegroup accounts than to deal with the individual statements and have to workout group totals.


Page 4

(ii) The goodwill figure is the difference between the cost of the group memberand the underlying reported assets acquired. When the group member is firstacquired the holding company will normally have paid a premium over thecost of the assets shown in the subsidiaryís balance sheet in order to acquiresuch assets as the companyís reputation and its work force. This balance isthen amortised over the life of the goodwill and so the balance shown in theconsolidated statements is the unamortised balance remaining.

The minority interest figure is the equity in subsidiary companies that isowned by outside investors. There is no need for the holding company to holdmore than a proportion of the shares in order to have control. Any amountremaining in the hands of third parties is a source of finance for the group, butit does not impose the same duties on the holding company as a directinvestment in the holding companyís shares.

This question produced some very good answers. Candidates tended to be aware of the issuesassociated with consolidations, although a minority of answers provided very weakexplanations.

15 (i) If the business is a partnership then both partners will be jointly and severallyliable for the debts owed by the business. This means that if the business failsthen they will have to make up any shortfall from their own pockets. It alsomeans that if one partner cannot or will not make settlement then the other willbe liable for the unpaid share and will have to make that good as well. Thisimplies the individuals trust each other, but in this case they have known eachother for a short time.

If the business is a limited company then the owners will not be directly liablefor its debts. If the business fails then both will be able to walk away andleave the unpaid creditors to gather as much as they can from any assetsremaining in the company. The company will, however, require more timeand effort to administer. If turnover grows they may also be forced to have anaudit.

(ii) Maudeís initial finance should be treated as a loan, for which she should bepaid a realistic rate of interest. If she receives additional shares then thismight mean that she will enjoy a disproportionate amount of profit if thecompany grows and succeeds. It will also mean that she will receive nothingin recognition of her advance while profits are poor. They should split theequity equally between them.

The owners should agree on salaries to provide them with some cash tosupport themselves on a day to day basis. This will ensure that they do nottake excessive amounts.

The remaining profit will then be available to pay dividends, although this willrequire the agreement of the owners, who should consider the need to leaveadequate funds in the business to ensure that it can grow in the future.


Page 5

The first part of this question was answered well, with candidates appreciating theadvantages and disadvantages of the different forms of business. The second part of thequestion was intended to test an appreciation of the real issues associated with going intobusiness. Very few candidates produced a realistic basis for sharing profits.

16 A company can use swaps to reduce risk by matching its assets and its liabilities. Forexample, a company which has short term liabilities linked to floating interest rates,but long term fixed rate assets can use interest rate swaps to achieve a more matchedposition. Currency swaps would be used by a company with liabilities in onecurrency and assets in another.

Companies can also use swaps to reduce the cost of debt. If one company has acomparative advantage in borrowing at a floating rate, while another company has acomparative advantage in borrowing at a fixed rate, they can use an interest rate swapto reduce the total cost of financing and both benefit from a lower cost of debt.

This question was generally answered well, although a minority of candidates appeared to beconfused over the uses of interest rate swaps.

17 (i) Required rate of return = 3+[8].0.6

= 7.8%

(ii) The total risk associated with an investment is not particularly important in thecontext of a diversified portfolio. A significant proportion of the risk in mostinvestments can be diversified away. In other words, factors such asmovements in exchange rates will have an adverse effect on some investmentsand a positive effect on others. The effect of investing in a portfolio is toreduce the overall volatility of the returns.

Risk can be separated into two components: systematic and unsystematic.Systematic risk is inherent in the political and economic environment and iscommon to all companies. For example, a change in energy prices will affectall companies to some extent. Unsystematic risk is specific to the company. Itencompasses a range of risks specific to the company such as changes inmarket demand for its products, stability of industrial relations, nature andlocation of its assets, and so on.

Systematic risk cannot be diversified away because it arises from factorswhich will have an effect on all companies. Thus, an increase in interest ratesor oil prices is likely to have an adverse effect on all companies and willdepress returns from the market as a whole. Unsystematic risk can bediversified away and, provided the investment is held in a properly diversifiedportfolio, it can therefore be ignored.

It is possible that a highly speculative investment will not be affected bygeneral market conditions to any great extent. That means that it will not have


Page 6

a high systematic risk. The volatility will, therefore, be due to unsystematicfactors that can be diversified away. That, in turn, suggests that theinvestment may require a very low return.

(iii) One approach is to use the companyís own beta coefficient. That is onlyrelevant, however, if the project is subject to the same risks as the company asa whole. That would suggest that investments which will amount to expansionof the business are subject to the same degree of systematic risk.

Another approach is to use the beta of a company which is engaged in thesame line of business as the project. That would be appropriate forinvestments which take the company into a new business sector.

A third possibility is to use historical data to estimate the betas of individualdivisions or segments of the main company. These betas can then be used as asurrogate for the coefficients of individual projects which fall within theirscope.

Finally, any of the above figures can be adjusted to allow for the effects ofhigh fixed costs. These will tend to reduce the variability of expenses tochanges in market conditions. In poor periods the revenues will be depressedwithout a corresponding decrease in expenses. That will increase the exposureof the company to changes in economic factors and will, therefore increasesystematic risk.

(iv) In theory, investing in a positive NPV project will increase shareholdersíwealth by the amount of that NPV. In practice, this change will only occur ifthe market is aware of the investment and agrees with managementís estimatesof the potential risks and rewards. It may be that the share price will not movein line with expectations because the market is not convinced that the risk isjustified or even because the directors have withheld important information forthe sake of commercial sensitivity.

If the directors wish to estimate the likely response to an investment then theyshould attempt to apply the same valuation models used by outside analystsand advisers in an attempt to determine how the information that they intendto publish will impact the share price. This might prove important because thecompany might prove vulnerable to a takeover bid if the market price of theshares is depressed by an adverse or lukewarm reaction to the news.

This question was intended to test some of the issues associated with the role of financetheory in investment decisions. It was generally answered well, with most candidatesdemonstrating an understanding of both CAPM and NPV. Part (iii) was, however, answeredbadly by many, with few practical suggestions as to how to estimate a projectís beta.

18 (i) B plc

Profit and Loss Account for the year ended 31 August 2002


Page 7

£000 £000

Sales 2,600.0Cost of sales ñ 1,006.5Gross profit 1,593.5Administration ñ 435.0Distribution ñ 850.0

ñ 1,285.0Operating profit 308.5Interest ñ 110.0Net profit before taxation 198.5Taxation ñ 40.0

158.5Dividend ñ 150.0

8.5Balance brought forward 180.0

188.5

B plc Balance Sheet as at 31 August 2002

£000 £000

Fixed Assets 2,463.5

Current AssetsStock 99.0Debtors 240.0

339.0

Current liabilitiesBank ñ 14.0Proposed dividend ñ 150.0Taxation ñ 40.0Creditors ñ 110.0

ñ 314.0Net current assets 25.0

2,488.5Loan ñ 1,400.0

1,088.5

Share capital 500.0Share premium 400.0Profit and loss account 188.5

1,088.5

Note ó Fixed Assets

Cost Aggregatedepreciation

Net bookvalue

£000 £000 £000

Land and buildings 2,300.0 ñ 249.0 2,051.0Machinery 900.0 ñ 487.5 412.5

3,200.0 ñ 736.5 2,463.5


Page 8

Workings

Cost of salestrial balance 800.0Plant depreciation 137.5Land and buildings depreciation 69.0

1,006.5

(ii) The depreciation charge should be based on the estimated useful lives of theassets. These should reflect the underlying nature of the assets themselves andshould be factually correct to the extent that it is possible for such an estimateto be so. If the directors were to distort this information with the intention ofdistorting the annual report then it would amount to deliberately misleadingthe shareholders and anyone else reading the financial statements. Apart frombeing morally wrong, this would be a criminal offence. The companyísauditors might identify the distortion and ask for an alteration to thestatements. If this was not made then they might find it necessary to qualifytheir audit report.

The directors are also required to disclose their main accounting policies. Ifthey are seen to be depreciating the companyís assets at a slower rate than theindustry norm then their scheme will simply draw attention to the fact thatprofit has been overstated.

Part (i) was designed to test the ability to prepare a simple set of financial statements. Thisproduced some very good answers, with very few candidates finding any real difficulty.

Part (ii) drew on the core reading, but also reflected some of the current unease with respectto the integrity of accounting information (which became even more topical in the periodimmediately prior to this diet). Many candidates correctly explained how an artificialunderstatement of depreciation would increase profits, but relatively few considered theassociated issues of whether accounting regulations would prevent companies from doing so.Still fewer referred to the moral implications of manipulating profits.


EXAMINATIONS

4 April 2003 (pm)













108 A2003ó2


1 Which of the following best describes a companyís ìauthorised capitalî?

A The amount of share capital it has issued.B The amount of share capital for which payment has been received.C The total amount of share capital it is allowed to issue.D The total amount of loan capital it has issued. [2]

2 Which of the following is NOT a disadvantage of using the internal rate of return(IRR) method of capital budgeting?

A Projects can have multiple IRRs.B IRR ignores the time value of money.C IRR does not provide a clear basis for deciding about an individual project.D It is difficult to determine an ìaverageî IRR for a range of scenarios. [2]

3 Which of the following would not normally be included in the calculation of gearing?

A bank overdraftB debenturesC ordinary sharesD preference shares [2]

4 Laura has just been admitted to a long established business partnership. She haspurchased 20% of the partnership equity, although she has not paid for this yet. Shewill be entitled to 15% of the partnership profit. If the firm incurs any liability, whatproportion of that liability will be Laura's legal responsibility?

A 0%B 15%C 20%D 100% [2]


5 X plc has issued both ordinary and preference shares. The directors have suspendedpayment of the preference dividend. Which of the following is UNLIKELY to betrue?

A The company will be unable to pay an ordinary dividend.

B The preference shareholders will be entitled to vote at the annual generalmeeting.

C The market value of the preference shares will decrease.

D The preference shareholders will be entitled to sue the company for non-payment of preference dividend. [2]

6 Beta plc is a quoted company. Which of the following is a specific risk that can bediversified away by shareholders?

A Beta plc is highly geared and it is exposed to increases in interest rates.

B Beta plc has a great deal of foreign competition and so changes in exchangerates can affect its competitive position.

C Beta plcís main product line requires a steady supply of a rare mineral that isonly found in a region that is politically unstable.

D Beta plc produces luxury goods, demand for which is highly vulnerable tochanges in the economic climate. [2]

7 When a firm announces a two-for-one stock split (in the absence of other newinformation), investors should expect that:

A earnings per share will fall but stock price will remain the sameB stock price will fall but earnings per share will remain the sameC both earnings per share and stock price will remain the sameD both earnings per share and stock price will fall

[2]

8 Bidder plc acquired all of the shares of Target Ltd for £4.5m. At the date ofacquisition Target Ltdís premises had a fair value of £1m, although their written downvalue according to its balance sheet was £0.6m. Other fixed assets were worth £0.8m.Net current assets were worth £0.1m. Long term liabilities were worth £1.3m. Thegoodwill on acquisition was:

A £2.6mB £3.0mC £3.9mD £4.3m [2]

108 A2003ó4

9 If a company has stock of £20,000, debtors of £30,000, bank deposits of £5,000,creditors of £22,000, and an overdraft of £11,000, then the quick ratio is:

A 1.1:1B 1.6:1C 1.7:1D 2.5:1 [2]

10 Which of the following is NOT true of investment trusts?

A They are owned by management companies.B They are companies which may be listed on the stock exchange.C They raise equity and debt capital.D They are run by a board of directors. [2]

11 T plc has never had a formal system of investment appraisal. The directors havedecided that, in future, managers must submit a formal proposal in respect of allinvestment projects and each project must have a payback period of five years or less.Describe the advantages and disadvantages of this new policy. [6]

12 Outline how the directors of a company can decide whether the accounting policiesthat they wish to adopt in their companyís annual report are acceptable. Your answershould refer to both legal and professional pronouncements. [8]

13 Explain how the tax liability of the life business and general annuity business of a lifeinsurance company is determined. [6]

14 The board of F plc, a major quoted company, intends to raise additional equity. Thedirectors have been advised to do so by means of a rights issue. State the advantagesof a rights issue as a method of issuing shares and explain the decisions that thedirectors have to make in the process of making this issue. [10]

15 Explain how the main types of derivative instrument might be used by a multinationalmanufacturing company in the aerospace industry. [10]


16 R plc is a quoted company. Its directors are reviewing the companyís long termfinancial strategy. The company has been criticised for being financed largely byequity. It has no significant long term borrowings. The board has asked for somecalculations to enable them to decide whether the company should considerborrowing in the future. The next phase of expansion will require the company toraise £200m and will involve a general expansion of the existing lines of business.

The following information has been obtained:

Current risk free rate 4%Equity risk premium 5%Current corporation tax rate 30%

Equity capital £1,000mR plcís Beta 1.4Probable gross interest rate on debt 7%

(i) Calculate R plcís expected weighted average cost of capital (WACC). [3]

(ii) Calculate R plcís expected WACC AFTER the new finance has been raisedassuming that the finance is raised by borrowing. [6]

(iii) Explain the relevance of the WACC figure to the decision to use equity or debtfor the new finance. [6]

(iv) It has been suggested that company directors are often motivated by a desire toact in their own best interests rather than those of the shareholders. Explainwhy directors might be reluctant to use the capital asset pricing model(CAPM) as a decision making criterion for financial planning. [5]

[Total 20]

108 A2003ó6

17 The following balances have been extracted from the books of JK plc, as at 31 March2003:

£000

Administrative expenses 150 Advertising 70 Cash at bank 10 Creditors 45 Debtors 115 Directorsí remuneration 75 Interest on long term loans 4 Investment income 18 Investments (short term) 350 Long term loans 200 Ordinary dividend paid 30 Ordinary share capital, issued and fully paid 700 Plant and machinery ó cost 210 Plant and machinery ó depreciation at 31 March 2002 95 Premises ó cost 950 Premises ó depreciation at 31 March 2002 20 Profit and loss at 31 March 2002 236 Purchases 600 Sales 1,760 Share premium account 50 Stock at 31 March 2002 130 Wages and salaries ó administrative staff 160 Wages and salaries ó manufacturing staff 190 Wages and salaries ó sales staff 80

Additional information:

1. Stock at 31 March 2003 was valued at £185,000.2. Provision is to be made for administrative expenses owing at 31 March 2003

amounting to £12,000.3. Premises are to be depreciated at the rate of 2% on cost, and plant and machinery

at 25% reducing balance.4. Advertising paid in advance at the end of the year amounted to £9,000.5. Corporation tax based on the yearís profit is estimated at £15,000.6. The companyís ordinary share capital is 700,000 £1 ordinary shares, fully paid.7. A final ordinary dividend of 5p per share is proposed.

Required

Prepare JK plcís profit and loss account for the year to 31 March 2003, and a balancesheet at that date. These should comply with Companies Act presentationrequirements. [20]


REPORT OF THE BOARD OF EXAMINERS

April 2003


EXAMINERSí REPORT

Introduction


J CurtisChairman of the Board of Examiners

3 June 2003



Page 2

1 C

2 B

3 A

4 D

5 D

6 C

7 D

8 C

9 A

10 A

Questions 1-10 were generally answered well.

11 A formal proposal will require explicit consideration of the cash flows associated withthe project. This will make it easier for management to decide on the overall impacton the companyís future performance. Payback is also relatively easy to understandand to implement.

Unfortunately, payback is probably the least relevant investment criteria. It ignoresthe time value of money. It ignores cash flows occurring after the end of the paybackperiod. It will also rank mutually exclusive projects in a manner that might be sub-optimal for the shareholders.

This question was answered well, candidates should however be careful in this type ofquestion to discuss cash flow rather than profit.

12 Company law lays down a host of detailed procedures relating to the form and contentof financial statements. These requirements include some prescriptions concerningaccounting policies , such as a requirement that the current assets other than debtorsshould be valued at cost or net realisable value if lower . The Companies Acts alsoprescribe the basic accounting concepts such as accruals, consistency and so on .

The accountancy profession has published a series of detailed accounting standards .These generally focus on areas where there have been problems with accountingpolicies in the past . For example, there are accounting standards on detailed matterssuch as the valuation of closing stock and the calculation of depreciation .


Page 3

Both company law and accounting standards require financial statements to give aìtrue and fair viewî . This provides a further benchmark against which to measure theacceptability of accounting policies . Do the financial statements give a true and fairview ?

The directors can also consider the consistency of their policies with those of othersimilar companies . Readers of financial statements will expect similar businesses tofollow broadly similar accounting practices .

Finally the directors can share the burden of ensuring the validity of their accountingpolicies with the auditors . The auditors will use similar criteria to those of thedirectors, but will provide an independent perspective in doing so.

Candidates should always be careful to answer the question rather than writingeverything they know about the topic. A number of candidates confused accountingconcepts and policies.

13 Insurance companies are taxed on their investment income and realised capital gains .These will have to be calculated in a manner that is acceptable to the Revenue .The company can offset life business expenses and general annuity business expensesfrom their income. Only permissible expenses can be deducted . For example,entertaining and depreciation charges must be excluded from costs for tax purpose .The income element of general annuity payments to policyholders may also be deducted.

The net income figure is the companyís taxable profit. This is then multiplied by theappropriate tax rate , as set by the government, in order to arrive at the final liability.

Generally this question was well answered.

14 The company is quoted. The stock exchange requires existing shareholders to havethe opportunity to purchase any new issues . Rights issues automatically grant thisopportunity to the shareholders . Rights issues also involve slightly lower issue coststhan other forms of selling new shares . The fact that the company is following thisìcommonî approach will also reduce the risk of unsettling the stock market by tryingsomething new.

The directors must decide on the most appropriate time for the issue . Ideally, itshould be at a time when the markets are likely to be most favourably disposed to thecompany. For example, if the annual report will be due in a few months and if it islikely to impress the markets then it might be better to delay the announcement . If thenext profit figure is likely to be slightly depressed then it might be better to movesooner .

The directors must also decide the issue price of the new shares . This must be lessthan the current market price, otherwise there ill be no point in exercising the rights .A large discount should not matter, at least in theory, because the shareholders canbuy these reduced price shares and avoid diluting their equity . Alternatively, a largediscount will increase the value of the rights themselves if the shareholders decide tosell rather than exercise them . Too large a discount could, however, unsettle themarkets .


Page 4

The directors must also decide how much information to release with respect to theunderlying reasons for the issue . They are required to make some disclosures in therights offer document , but they might decide to publish more detail in order to appearopen and transparent and win the trust of the markets . Too much disclosure could,however, cost the company competitive advantage because competing businesseswill make a point of obtaining a copy.

This question was really well answered most candidates were well prepared.

15 This company is likely to have large contracts that involve substantial payments atfuture dates. The company could use currency futures to ìlock inî the exchange rateof receipts or payments that have been agreed for a future date and in a foreigncurrency . This will protect the company from the risk of liabilities appreciating invalue or assets declining in value before they fall due to be settled.

The company can also sell its own specialised futures or options as an incentive tocustomers. It is common in this industry for airlines to take options on aircraft. Thesegive the airline the right, but not the obligation, to purchase by a predetermined datebut at a fixed price . This means that the airline is protected from any price increases .The company also benefits because it can retain the cost of the option, even if thecustomer decides not to buy.

The company is likely to have operations around the world. It might be able to makeuse of currency swaps in order to reduce its total cost of borrowing. For example, itmight have a comparative advantage in borrowing in the main currency of it basecountry . It might enter into a reciprocal agreement with a borrower in a host countrywho has a corresponding comparative advantage . The two parties can exchange aseries of payments so that each has access to finance in their desired country andcurrency, but payable on terms that have been negotiated with their counterpart .

The company might also be able to use interest rate swaps in a similar way if it has asimilar form of advantage (say in borrowing at a fixed rate) that can be shared withanother company with a corresponding advantage (say in borrowing at a variablerate).

This question was poorly answered with many candidates giving a general answer onall types of derivatives. Candidates should always try to be as specific as possible.

16 (a) WACC = cost of equity

Cost of equity = 4% + (1.4 x 5%) = 11% [2]

(b) Gearing = 200:1,000 = 0.2


Page 5

Geared beta = 1.4 x (1+(0.2 x (1-0.3)) = 1.596 [2]

Cost of equity = 4% + (1.596 x 5%) = 11.98%

Net cost of debt = 7% x (1-.3) = 4.9%

WACC = (11.98% x 1,000 / 1,200) + (4.9% x 200 / 1,200) = 10.8%

(c) The company should, ideally, minimise its WACC. In theory, doing so willmaximise the expected cash flows that it will generate and so increase itsmarket capitalisation . If it raises the additional finance from shares then it willhave 100% equity and so its WACC will be 11% . It would, therefore, beslightly cheaper to borrow the £200,000 .

The problem is that this comparison is not quite valid because of the risksassociated with borrowing . If the company borrows then it will run the risk ofbeing unable to make interest payments when they fall due . Earningsavailable to the shareholders will also be more volatile because of gearing .This could mean that the shareholders will actually feel that the company is apoorer investment, even though it is benefiting from the cheaper debt financeand its associated tax advantages .

It should also be noted that R plcís ungeared beta is relatively high at 1.4 .This means that the companyís shares are already a slightly risky propositionwhen taken on their own. Adding the additional risks associated with gearingmight make things even worse .

(d) CAPM assumes that investors have a portfolio of assets . A companydirectorís principal asset will be his or her job . CAPM assumes that any andall unsystematic risks can be diversified away . The directors are, however,exposed to both systematic and unsystematic risks . Companies sometimesreduce this problem slightly by rewarding directors with stock options, therebyproviding an incentive to introduce some volatility into the companyís shareprice performance , but these are unlikely to be a sufficient incentive to investin highly risky investments. The directors might also be concerned that theshareholders will not view any investments from a CAPM perspective. CAPMis not especially intuitive and so the directors might be concerned that themerits of their decisions will not be understood .

This question was very well answered by most candidates


Page 6

17JK plcProfit and loss account for the year ended 31 March 2003

£000 £000

Turnover 1,760 Cost of sales (783) Gross profit 977 Selling and distribution costs (141) Administrative expenses (397)

(538) Operating profit 439 Interest paid (4) Investment income 18

14 Profit before taxation 453 Taxation (15) Profit on ordinary activities after taxation 438 Dividends (65) Retained profit for the year 373 Balance brought forward 236 Retained profits carried forward 609

JK plcBalance sheet at 31 March 2003

£000 £000Fixed assets 997

Current assets Stock 185 Debtors 115

Investments 350 Prepaid expense 9 Bank 10

669 Creditors: amounts falling due within one year Creditors (45) Accrued charge (12) Corporation tax (15) Proposed dividends (35) (107) Net current assets 562

1,559 Creditors: amounts falling due after more than one year Long term loan (200)

1,359

Share capital and reserves Ordinary share capital 700 Share premium 50 Profit and loss account 609

1,359


Page 7

Workings£000

Cost of salesOpening stock 130 Purchases 600 Closing stock (185) Depreciation - premises 19 Depreciation - plant and machine 29 Wages and salaries 190

783

Selling and distributionAdvertising 70 Less - prepaid (9) wages and salaries 80

141

Administrative expensesAdministrative expenses 150 Add - accrual 12 Directors' remuneration 75 Wages and salaries 160

397

DividendsPaid 30 Proposed 35

65

Fixed assets

Cost Aggregate

depreciation Net book

value Premises 950 39 911 Plant and machinery 210 124 86

1,160 163 997

This question was designed to test the candidatesí ability to prepare a profit and loss accountand balance sheet. Most candidates could calculate the correct figures but many lost marksfor incorrect formats.


EXAMINATIONS













! Faculty of Actuaries108—S2003 ! Institute of Actuaries

108 S2003—2

For questions 1–10 indicate in your answer booklet which one of the answers A, B, C or D iscorrect.

1 Which of the following statements is correct?

A External auditors report to the directors.B External auditors are required to give a report to the shareholders.C External auditors correct errors in financial statements.D External auditors are appointed by the directors. [2]

2 Which of the following types of financial instrument is best described as follows: afixed return, a fixed repayment date, it is secured and the return is classified as anexpense?

A medium term bank loanB preference shareC ordinary shareD debenture [2]

3 Jennifer successfully applied to buy shares that had been offered for sale by tender.She tendered to pay £2.40 per share. The maximum tendered by any applicant was£2.50. The average tendered was £2.20. The strike price was £2.30. How much didJennifer pay for each of the shares that she received from the company?

A £2.20B £2.30C £2.40D £2.50 [2]

4 A plc owns shares in three companies, B Ltd (40% shareholding), C Ltd (100%shareholding) and D Ltd (25% shareholding). C Ltd also owns 30% of the shares ofD Ltd. A plc has a contractual right to appoint two thirds of the board of B Ltd. Aplc has used its voting rights to appoint all of the directors of C Ltd. Whichcompanies are subsidiaries of A plc?

A C onlyB B and C onlyC B, C and DD none of the above [2]

108 S2003—3 PLEASE TURN OVER

5 A company’s share capital comprises 40,000 20 pence ordinary shares, which were allissued at a premium of 25%. The shares are fully paid up. The market value of theshares is currently 50 pence each. The figure for ordinary share capital appearing inthe company’s balance sheet will be:

A £8,000B £10,000C £18,000D £20,000 [2]

6 In times of rising prices, the historical cost convention has the effect of:

A understating profits and overstating balance sheet itemsB understating profits and understating balance sheet itemsC overstating profits and overstating balance sheet itemsD overstating profits and understating balance sheet items [2]

7 Assume the current corporation tax rate is 30%. The directors of ABC Ltd weresurprised when they received a corporation tax assessment for less than 30% of itsreported profits. Which of the following items may have contributed to ABC Ltdreceiving a tax assessment which was lower than anticipated?

I losses carried forward from previous yearsII capital allowances which are higher than depreciationIII entertaining expenses which are disallowed for tax

A I onlyB II onlyC I and II onlyD I and II and III [2]

8 Which of the following would NOT appear in a cash flow statement, in the“reconciliation of operating profit to net cash inflow from operating activities”?

A DepreciationB WagesC Increase in creditorsD Increase in stocks [2]

108 S2003—4

9 A company is planning to expand and has prepared a set of discounted cash flowcalculations for consideration by the board of directors. Prior to the final decision, thecompany’s weighted average cost of capital has increased. How will this affect thediscounted cash flow results?

A Net present value will decrease and internal rate of return will decrease.

B Net present value will decrease and internal rate of return will increase.

C Net present value will decrease and internal rate of return will remain thesame.

D Net present value will increase and internal rate of return will remain thesame.

[2]

10 Which of the following institutions do not normally invest in short dated gilts?

A General Insurance CompanyB Discount HouseC Life Insurance CompanyD Clearing Banks [2]

11 Your company has traditionally used the net present value criterion for analysinginvestment opportunities. It has recently been proposed that it should switch to ashareholder value approach. Discuss the advantages of doing so. Your answer shouldconsider the problems that would have to be overcome in order to implement thisapproach successfully. [8]

12 Explain how a company’s UK corporation tax liability is calculated and when it mustbe paid. [6]

13 One of your relatives has recently received a substantial sum of money. He is keen toinvest this for long term growth, so that he can provide for his retirement. He wouldlike to invest in the shares of the quoted company for which he has worked for thepast twenty years. He already owns some shares in that company and has alwaysbeen satisfied with the returns that he has obtained.

Explain why it would be inadvisable for your relative to invest this sum in a singlecompany, even one which he knows well and which has performed well in the past.Your answer should refer to the principles underlying the capital asset pricing model(CAPM). [6]

108 S2003—5 PLEASE TURN OVER

14 Explain how the Bank of England traditionally provided liquidity in the moneymarkets, and how it provides liquidity now. [6]

15 The board of a major quoted company is considering making a scrip issue. It isweighing up the costs of doing so against the expected benefit in terms of a possibleshort-term boost to the company’s share price.

Describe the costs associated with making a scrip issue and explain how it couldincrease the share price. [6]

16 The treasurer of a major multinational company is preparing a proposal to the boardthat the company should issue Eurobonds for the first time. The directors are unsurewhat is involved and have sought clarification of the issues involved.

Explain the advantages and disadvantages of the use of Eurobonds to an issuer. [8]

17 Trevor and Simone are directors of Make Ltd, a wholly owned subsidiary of a largegroup of companies. Make Ltd manufactures packaging for the other companies in thegroup.

The directors of the group’s holding company have approached Trevor and Simoneand have offered to sell them Make Ltd. If Trevor and Simone accept this offer, thegroup will continue to buy its packaging materials from Make Ltd for three years,after which time Make Ltd will have to compete for this business against othermanufacturers. Make Ltd will be also be free to find new customers who are not partof the group. If Trevor and Simone do not accept the offer then the group willprobably make the workforce of Make Ltd redundant and close the company down.They will then obtain their packaging from independent suppliers, probably fromoverseas.

Trevor and Simone have discussed this proposal. They could each raise 25% of theasking price by remortgaging their homes. They could raise the remainder of the priceby inviting the workforce of Make Ltd to buy shares.

In the medium term, Make Ltd will have to invest heavily in new technology in orderto compete for new business.

In the short term, Make Ltd will have to rearrange its short term finances to reflect thefact that it is no longer part of the group.

(i) Explain the main issues that Trevor and Simone should consider beforecommitting themselves to acquiring this interest in Make Ltd. [8]

(ii) Describe the main sources of finance that Make Ltd should consider for theacquisition of new manufacturing equipment. Assume that this acquisition willonly be made if the purchase of the company is completed. [6]

(iii) Describe the main sources of short term finance that will have to be organisedby Make Ltd if Trevor and Simone complete the purchase. Describe the mainproblems that will have to be overcome when obtaining each form of finance.

[6][Total 20]

108 S2003—6

18 PJ plc is a large retailer which sells electrical goods to the public. Every year theboard obtains copies of the financial statements of their two main competitors:Pricecut and Bigstore. The directors of PJ plc try to obtain insights into theircompetitors' business practices so that they can improve their own performance.

The summary financial statements of the three companies are shown below:

Profit and loss accounts for the year ended 30 June 2003

PJ plc Pricecut Bigstore £000 £000 £000

Sales 5,000 4,000 11,000Cost of goods sold (1,500) (2,000) (2,750)Advertising (400) (480) (880)Sales staff (350) (400) (880)Other expenses (600) (160) (1,430)Net profit 2,150 960 5,060

Balance sheets as at 30 June 2003

PJ plc Pricecut Bigstore £000 £000 £000

Tangible fixed assets 5,000 1,300 8,000Current assetsStock 123 99 286Bank 10 3 17

133 102 303

Current liabilitiesCreditors (115) (82) (286)Net current assets 18 20 17

Total assets less current liabilities 5,018 1,320 8,017

Share capital and reserves 5,018 1,320 8,017

(i) Discuss the main differences between PJ plc’s business practices and those ofPricecut and Bigstore, using relevant ratios to support your answer. [15]

(ii) Describe the limitations of the annual report as a basis for the comparison ofcompanies in the manner suggested by the directors of PJ plc. [5]

[Total 20]


REPORT OF THE BOARD OF EXAMINERS

September 2003


EXAMINERS’ REPORT

Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The questions and comments are based around Core Reading as the interpretation of the syllabus to which the examiners are working. They have however given credit for any alternative approach or interpretation which they consider to be reasonable. J Curtis Chairman of the Board of Examiners 11 November 2003 ¤ Faculty of Actuaries ¤ Institute of Actuaries


EXAMINATIONS

September 2003


EXAMINERS’ REPORT

¤ Faculty of Actuaries ¤ Institute of Actuaries


Page 3

1 B 2 D 3 B 4 C 5 A 6 D 7 C 8 B 9 C 10 C In Questions 1-10 there were no particular problems with the objective test questions, with most candidates scoring a reasonable mark. 11 Shareholder value reflects the impact of any investment decision on the wealth of the

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

The biggest problem to be overcome in applying this approach is in predicting how

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


Page 4

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

This question was answered quite badly. In many cases this appeared to be due to candidates either being unaware of the shareholder value approach or providing a “prefabricated” answer on the net present value criterion. 12 Corporation tax is charged on the annual accounting profit. This figure is, however,

adjusted to take account of a variety of adjustments. These adjustments include the replacement of depreciation with capital allowances, the exclusion of disallowed expenses such as entertaining and the exclusion of franked investment income from profit.

Some companies are also entitled to exclude profits earned overseas because of

double tax relief provisions. These profits will be taxable in the jurisdiction where they are earned, but not in the home country.

The tax rate is announced by the government, usually on an annual basis. Corporation tax is normally paid nine months after the year end. Large companies are,

however, required to pay their tax on a quarterly basis. This question was answered well, demonstrating awareness of the basic principles of UK corporation tax. 13 The return on a security is largely related to the risk that is borne by an investor. This

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

Investing in a single company will mean that the relative is being rewarded for the

systematic risks associated with the security, but not the unsystematic . That means that the return will not adequately compensate for the risks undertaken .

Common sense also dictates that the investor runs the risk of losing everything from

investing in a single company if that company fails . The fact that this person also works for that company could mean the loss of both his job and his savings if the company collapses .


Page 5

Most candidates provided sensible answers to this question. Better answers highlighted the practical implications of the CAPM for investors without becoming bogged down in technical detail. 14 Traditionally, the Bank of England used discount houses as a buffer between itself

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

The Bank of England still acts in a supporting role for the various institutions that are

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

If the money markets are short of cash, Treasury bills, local authority bills and bills of

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

The Bank of England also provides cash to the market by lending cash against bills

deposited on security , and by purchasing bills with a simultaneous agreement to sell at a later date (known as “repo” arrangements) .

The quality of answers to this question varied considerably. Weaker answers were generally short of detail and gave the impression of a lack of familiarity with the subject matter. While the examination is designed to avoid testing recall of facts, candidates should attempt to understand the role and behaviour of institutions and the frameworks in which they operate. That should develop sufficient familiarity with the basic facts to deal with questions such as this. 15 The scrip issue does not require many formalities. It does, however, involve some

administrative effort and therefore cost . The company will have to write to shareholders and inform them that the issue is taking place . This will also have to be announced publicly to prevent anyone being misled and buying or selling at a time when the rights to scrip shares are lost . The shareholders themselves will also suffer an element of irritation because they will have to keep detailed records of the change in their holdings for tax purposes .

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

shares themselves . It is unlikely that the issue itself will make the company a better investment . It could,

however, be interpreted as a signal of confidence on the part of the directors . For


Page 6

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

This answer was answered well, with candidates demonstrating understanding of both the mechanics of scrip issues and their role in signalling confidence to the markets. 16 One of the advantages of Eurobonds is that they are issued outside of the tax and legal

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

Eurobonds normally have fixed coupon rates, although floating rate bonds can be

issued . Bonds are normally unsecured . Eurobonds are bearer bonds . The company does not keep a register of owners;

instead holders must claim coupon payments using coupons cut out of the certificates . A possible disadvantage for the company is that it may have very little real idea of the identity of the holders of its bonds .

The nature of these instruments means that the company must have a strong

reputation, otherwise the general absence of regulation may mean that the lenders will be deterred from buying the issue .

Eurobonds cannot be issued for small amounts, but must be issued in large blocks .

Issues are generally for $75m or more . Answers to this question were very variable, with weaker candidates struggling to demonstrate any real understanding of the Eurobond markets. 17 (i) Trevor and Simone are effectively faced with two alternatives. If they invest in

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

If they do not buy this company then it appears that their employers will make

them redundant . This means that, by buying the company, they will suffer the opportunity cost of the redundancy pay that they would have received if the company was closed down .

Given the importance of the future prosperity of the company, it is worth

considering the motives of the holding company . It appears committed to either selling or liquidating its subsidiary . This suggests that it can obtain


Page 7

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

(ii) Make Ltd might find it difficult to borrow in order to expand because it is a

small company that does not have the backing of a larger entity . The shareholders are unlikely to be able to provide much fresh finance or to guarantee loans for the company because they will be stretched by the cost of buying out the existing owners .

Leasing would be a suitable means of acquiring specialised plant because it

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

Hire purchase would be a similar form of finance to leasing in the sense that

the asset would provide its own security for the duration of the loan period . The third possibility would be a term loan to enable the company to buy the

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

(iii) The most important source of short term finance is trade credit . This is

effectively a “free” source of finance since its cost is built into the cost price of the goods, but this is unlikely to be discounted for immediate cash payment . It is also a very flexible source of finance, that expands and contracts in line with the company’s requirements .

The creditors are under no obligation to continue to support Make Ltd after the change of ownership . They might be concerned that the company no longer has the strength of a large group behind it . They might also be concerned that any attempts to expand could create cash flow problems that might threaten the company’s ability to meet its short term debts .

As a matter of priority, Trevor and Simone should meet with their principal

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

The second important source of short term finance is the company’s bank

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


Page 8

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

Trevor and Simone should seek a meeting with their bank manager to

negotiate an adequate overdraft facility . This might prove difficult because overdrafts are not normally secured . The bank might be nervous about supporting this new venture .

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


Page 9

18 (i) The following ratios are relevant: Profitability

PJ plc

Pricecut

Bigstore

Return on capital employed

2,1505,018

43% 960

1,320

73% 5,0608,017

63%

Gross profit percentage 5,000 1,5005,000� 70% 4,000 2,000

4,000�

50% 11,000 2,75011,000

� 75%

Advertising / sales 4005,000

8% 480

4,000

12% 88011,000

8%

Sales compensation / sales

3505,000

7% 400

4,000

10% 88011,000

8%

Fixed asset turnover (times)

5,0005,000

1.0 4,000

1,300

3.1 11,0008,000

1.4

Activity

Stock turnover (days) 123 3651,500

u 30 99 365

2,000u

18 286 3652,750

u 38

Creditors turnover (days)

115 3651,500

u 28 82 365

2,000u

15 286 3652,750

u 38

Pricecut appears to have a much smaller markup than PJ plc on its selling

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

Pricecut also has a greater fixed asset turnover. This suggests that it has

consciously minimised its investments in fixed assets in order to maximise return on capital employed .

Finally, Pricecut pays its suppliers very quickly, suggesting that it buys a

proportion of its goods for cash or that it is keen to maintain supplier support . Overall, Pricecut appears to be a low cost, low status supplier, possibly selling

in the cheaper end of the market . This approach generates a higher return on capital employed than PJ plc and so might be worth considering . It could, however, be risky to adopt this policy because it would provoke direct price competition with an established competitor .

Bigstore has a higher margin than PJ plc on its sales . It has managed to achieve higher sales and so it manages to spend a much greater absolute


Page 10

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

Bigstore has a slower stock turnover than PJ plc, suggesting that it carries a

wider range of stocks or that it sells more expensive brands or ranges . Bigstore appears to be a high status, high cost supplier concentrating on the

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

(ii) The financial statements could be based on different accounting policies.

Many of the differences identified in (i) above could be due to the manner in which the figures have been prepared .

Some companies will disclose as little as possible about their business

strategies in order to avoid giving useful information to competitors . Comparisons could be misleading because of the effects of inflation or

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

There might not be sufficient detail to make some of the comparisons provided

above. For example, the statements might not disclose the amounts paid to sales staff .

The working capital sections of the balance sheets could be affected by

window dressing or other factors . For example, one of the companies could have had a sale just before the year end so that the stock figures were artificially low .

Part (i) tended to be answered well by candidates who understood the technique of ratio analysis. Good answers provided a range of relevant ratios and made use of these in providing a considered analysis of the companies. Weak answers often provided more ratios than was necessary and failed to draw any form of reasoned conclusions in their analysis. Part (ii) tended to be answered well, with many candidates demonstrating some understanding of the problems affecting the preparation of financial statements.


EXAMINATIONS

29 April 2004 (pm)

Subject 108 Finance and Financial Reporting



1. Enter all the candidate and examination details as requested on the front of your answer booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the supervisor.


4. Attempt all 17 questions. From question 11 onwards begin each answer on a separate sheet.



Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this question paper.

In addition to this paper you should have available Actuarial Tables and your own electronic calculator.

Faculty of Actuaries 108 A2004 Institute of Actuaries

108 A2004 2

For questions 1 10 indicate in your answer book which one of the answers A, B, C or D is correct.

1 Which of the following is not explicitly required by the UK Companies Act?

A Directors report B Auditor s report C Chairman s report D Notes to the accounts

[2]

2 Kate is an employee of an insurance company in the UK.

Kate receives additional benefits such as free medical insurance cover. What effect will these benefits have on her income tax liability?

A The benefits are not subject to tax because they are not in the form of cash.

B She will be taxed on the benefit at a lower rate than the rate of tax applied to her salary.

C She will be taxed on the benefit to her of receiving these benefits.

D She will be taxed only on the benefits that are not provided in the normal course of the company s business.

[2]

3 A company s long term finance comprises: ordinary shares £10m, share premium £8m, preference shares £3m, debentures £6m and long terms loans £5m. What is the company s gearing ratio?

A 19% B 34% C 44% D 69%

[2]

4 Sam owns 1,000 £1.00 ordinary shares in T Ltd. These shares were purchased from the company for £1.25 each. Sam has paid £0.80 per share to date and the shares are deemed £0.45 paid up. What would be the maximum that Sam could be made to pay to T Ltd s creditors if the company fails and leaves unpaid liabilities?

A £550 B £800 C £1,000 D £1,250

[2]

108 A2004 3 PLEASE TURN OVER

5 Frank submitted a tender to buy 2,000 £1.00 shares in X plc. He offered £3.00 per share. Tenders received varied from £1.50 to £3.60. The striking price was set at £2.40. How much will Frank have to pay for his allocation of 2,000 shares?

A £2,000 B £4,800 C £6,000 D £7,200

[2]

6 Grow plc owns sugar cane plantations in the Caribbean. In April 2004 it buys an option to give it the right to purchase refined sugar at a predetermined price at some time in the future. Which of the following is the LEAST likely explanation for Grow plc s purchase?

A Grow plc is concerned that this year s crop will fail.

B Grow plc wishes to hedge against price changes on the commodity markets for sugar.

C Grow plc s knowledge of the industry leads it to believe that it can make money from speculating.

D Grow plc is attempting to drive up the cost of refined sugar. [2]

7 Preference share capital has been more popular in recent years. Which of the following is the most likely explanation for this?

A Preference dividends are more tax efficient than ordinary dividends. B Preference shares are always redeemable. C Preference shares can be structured so as to improve the issuer s gearing ratio. D Preference shares impose no risks on the ordinary shareholders.

[2]

8 Owner plc owns 60% of the ordinary share capital of M Ltd and classifies M Ltd as a subsidiary. Owner plc owns 25% of the ordinary share capital of O Ltd and classifies O Ltd as an associate company. Each of the three companies have tangible fixed assets worth £1m. What total will appear under tangible fixed assets in the consolidated financial statements published by the Owner Group?

A £1.6m B £1.85m C £2.0m D £3.0m

[2]

108 A2004 4

9 Which of the following is the best reason for NOT referring to the working capital section of a company s latest balance sheet when deciding whether that company is a good risk for purposes of granting trade credit?

A A company s liquidity says nothing about its ability to pay debts. B It is reckless to base such decisions on information provided by the customer. C The figure for working capital is likely to be distorted. D The information will almost certainly be out of date.

[2]

10 Which of the following is true of unit trusts?

A Unit trusts are quoted on the Stock Exchange. B Unit trusts are not companies. C Unit trusts are allowed to have gearing. D Unit trusts have no initial charge.

[2]

11 Compare a finance lease with a medium-term loan as a means of acquiring a fixed asset. [6]

12 Peter and Susan cannot understand why their business is short of cash as it made profits of over £100,000 last year. Explain why there can be differences between profits or losses generated, and cash received.

[8]

13 Q Ltd is a general trading company that is domiciled for tax purposes in the UK. The directors are considering setting up an overseas subsidiary but are concerned that they might end up paying tax twice on the subsidiary s profits, once in the host country and a second time when the profits are remitted back to the UK. Describe the principles of double taxation relief (DTR) as they would apply to Q Ltd. [6]

14 Terry and Julie have decided to establish their own actuarial consultancy. They have identified a gap in the consultancy market for their services and are keen to start trading as a partnership soon. First they have to go through the process of creating and financing their business.

Identify the financing needs of this business and explain how these might best be met from the various alternatives available. [10]

15 Describe the operation of self-administered pension funds in the UK and explain how the factors that govern their operation influence their choice of investment.

[10]

108 A2004 5 PLEASE TURN OVER

16 G plc is a quoted company in the telecommunications industry. The government has offered a licence for the use of a new broadcast technology that could revolutionise the sector in which G plc operates. This would initially operate in parallel with existing communications media, but has the potential to become the standard technology within the next ten years. The directors believe that they would have to bid £800m in order to secure this licence in competition with the other companies in the industry.

G plc s market capitalisation is £4,000m. If it decides to bid for the licence and is successful then it will have to raise most of the cost through the combination of a rights issue and a loan from a consortium of commercial banks.

G plc s directors are unsure whether to proceed with the bid. One aspect of their decision is the question of whether the potential returns from this project are adequate to compensate for the risks involved. They have obtained the following information:

Current risk free rate 5% Equity risk premium 7%

G plc s Beta 1.8

(i) Calculate the required rate of return from this investment, using G plc s Beta coefficient as a proxy for the project Beta. [3]

(ii) Explain why G plc s Beta is likely to be an appropriate approximation for the project Beta and explain how a more appropriate project Beta might be determined. [6]

(iii) Explain the limitations of the capital asset pricing model (CAPM) in making a decision about a project of this size and nature. [6]

(iv) Assuming that the directors of G plc make a successful bid for this project, explain how the stock market is likely to react to the news and explain how that reaction might best be managed by the company. [5]

[Total 20]

108 A2004 6

17 The Insurance Group has recently published an annual report. This contains the following summarised balance sheet:

Insurance Group

Consolidated balance sheet as at 31 March 2004

Assets £m

Intangible assets

Goodwill on acquisition of subsidiary 4

Investments 278

Reinsurers share of technical provisions

Claims outstanding 110

Debtors 80

Other assets

Tangible assets 6

Cash at bank and in hand 35

41

Prepayments and accrued income 14

Total assets 527

Liabilities

Capital and reserves

Called up share capital 50

Share premium account 22

Profit and loss account 9

Shareholders funds attributable to equity interest 81

Technical provisions

Claims outstanding 386

Creditors 60

Total liabilities 527

108 A2004 7

Required

The following questions have been posted to an internet chat site devoted to the Insurance Group. Outline your response to each question, taking account of the specific interests of each person asking a question.

(i) Insurance (Accident) Ltd, a wholly owned subsidiary of the Insurance Group, owes me substantial compensation which will be paid in six months time. Insurance (Accident) Ltd has massive liabilities and almost no assets. When I wrote and asked for some assurance that they were capable of paying my settlement they sent me the group balance sheet and stated that they were part of a large and solvent group of companies. Explain whether I should accept this reassurance . [5]

(ii) I am a shareholder in Insurance (Holdings) plc, the holding company of the Insurance Group. I have the following questions:

(a) Every year the financial statements show that a proportion of the goodwill on the acquisition of a subsidiary has been written off. Why is this adjustment necessary and what does it mean for the value of my investment? [5]

(b) The notes to the financial statements explain that the company has estimated the amount payable in respect of claims from policyholders and also the amount recoverable from reinsurers. Why should the financial statements contain such estimates when their value must be the subject of some doubt? [5]

(c) How can I be certain that these financial statements have not been falsified by dishonest directors? [5]

[Total 20]

END OF PAPER


EXAMINATIONS

April 2004


EXAMINERS REPORT


Subject 108 (Finance and Financial Reporting) April 2004

Examiners Report

Page 2

1 C 2 C 3 C 4 A 5 B 6 B 7 C 8 C 9 D 10 B

All questions in this section were answered well apart from a common error in question 3. The only potentially correct answer is C because preference shares should be treated as debt in the gearing ratio. Borderline candidates who missed this point were reviewed and given some credit for question 3 where this made a difference.

11 Both methods would give the use of the asset for its useful life. Both have the effect of increasing borrowing in the company s balance sheet. The cost of each is likely to be of broadly equal size. The concept of borrowing is rather simpler than the concept of leasing. That can make the bookkeeping arrangements for a loan rather simpler. Leasing an asset does not lead to transfer of legal ownership. Borrowing offers scope for negotiating the form of the loan. For example, the borrower might opt for a variable rate or the right to repay early. Leasing is unlikely to be as flexible.

This question was answered well by most candidates.

12 The calculation of profit involves a number of adjustments that do not involve any cash flows. Depreciation, gains or losses on disposal of fixed assets, accrued income and expenses affect profits but not cash flows. Conversely, there are many different transactions that can affect cash flows without any impact on the profit and loss account. For example, receipts and payments of loans, acquisitions and disposals of fixed assets, issue of shares all affect bank but not profit.

In the very long term total profit and net cash flow should be roughly the same . Over time, the cost of fixed assets and the total depreciation charged will come into line with one another . That does, however, require a very long term outlook.

If the business is growing then it is possible for increased profits to be associated with a decline in cash. The growth is often associated with additional investment in stock and debtors and that can lead to an outflow of cash. Furthermore, the fact that the company has done well might encourage an excessive dividend payment, more than the company can afford in cash terms.


Examiners Report

Page 3

An alternative reason for differences may be fraud or error in the business accounting system.

This question produced some very weak answers. Many candidates were not capable of explaining the difference between profit and cash flows in the common sense manner implied by the question.

13 The first issue is whether the country that Q Ltd will be operating in has a DTR treaty with the UK. Many countries do, but not all .

If a treaty is in place then Q Ltd will be able to offset tax paid overseas against the liability to UK tax on that income. The maximum offset is the rate of tax that would have been payable in the UK.

Q Ltd can only claim DTR in respect of income-based tax. No relief is available for tax of a capital nature .

This question was well answered. Most candidates were aware of the nature of double taxation relief.

14 The business will require some initial funding in order to provide drawings for the owners living costs while they become established and also to provide for basic requirements of office equipment, stationery, etc. . Initially there are three main sources: owners capital , a bank loan and a bank overdraft .

Owners capital has the advantage of being flexible . It is a matter for Terry and Julie to decide how much each should contribute. Thereafter they are only accountable to each other . Arguably, the two of them will have greater confidence in the business than outside investors and so this might be the easiest way to raise money . This does, however, leave them exposed to any problems with the business. If it fails then they will have spent their savings and will have nothing to fall back on .

A bank loan has the advantage of providing an agreed source of finance right from the beginning of the business . The bank might, however, demand personal guarantees from Terry and Julie and so the exposure might be almost as great as for personal investment . The business will also have to generate sufficient cash right from the start to service the loan and so that will put them under some pressure .

An overdraft is a flexible form of finance, most suited to meeting day to day requirements . One advantage is that interest is paid only on the amount outstanding . A major disadvantage is that the bank can demand the repayment of the overdraft at any time, without any particular reason . An overdraft is also likely to have higher interest charges than a loan .

Most candidates applied their understanding of the material in the core reading to this simple scenario.


Examiners Report

Page 4

15 A self-administered pension fund aims to provide pensions for employees when they retire . Almost all are funded by contributions from both employers and employees throughout the working lives of members . The funds are normally established by employers who make contributions of a sum determined by an actuary or as set out in the fund rules . The employer will also collect contributions as deductions from employees salaries and will pay those into the fund on the employees behalf .

The trustees of a self-administered pension fund are responsible for its investment strategy . Trustees must act in accordance with the trust deeds and rules, and in the best interests of the beneficiaries .

The funds liabilities are long-term, relatively open-ended and are automatically adjusted for inflation when pensions are linked to final salary . This means that they need to invest in real assets that are likely to maintain their values in times of rising values . Historically, most funds invested heavily in equities, but now more funds are investing in a wider range of activities .

Some assets are in the form of very secure investments such as stocks and bonds in order to obtain some return from working capital . The long term nature of the liabilities is likely to mean that any investment in bonds is likely to be an investment in long dated bonds.

This question tested knowledge of self-administered pension funds. It caused no particular difficulty for most candidates.

16 (i) Rate = 5% + (1.8 7%) = 17.6%

(ii) This model is only appropriate where the project is subject to the same systematic risks as the company as a whole . This might be the case here because the investment is fundamentally in the same industry as G plc . On the other hand, a new form of telecommunication (e.g. a new form of digital television or the latest mobile phone) might be regarded as more of a luxury item . That could make adoption far more dependent on the state of the economy than the flow of revenue from existing technologies .

The company should consider the fundamental nature of the project in order to understand its underlying sensitivity to movements in the market . The beta of existing telecommunications companies is an appropriate starting point. If this product is a must have then it might not be sensitive to factors such as interest rates or exchange rates . That would suggest a lower beta . If it is a luxury then it might be more appropriate to compare it to other forms of consumer spending such as designer clothing . Risks associated with the technology itself or the detail of the market can be diversified away and can be ignored.


Examiners Report

Page 5

(iii) CAPM is ideal if the directors are primarily interested in the needs of the shareholders. The shareholders can diversify away the unsystematic risks associated with the large project. There could, however, be a problem if the project is so large as to affect the company s beta . That might alter the balance of the shareholders investment portfolios and leave them open to more risk than they would wish to accept.

CAPM might create a conflict between the interests of the directors and their shareholders. The shareholders can diversify, but each of the directors is likely to have only one major appointment and only one reputation. The directors are more exposed to the total risk of the project and might not pursue investments that are in the shareholders interests.

(iv) The stock market may view this investment as a risk and the share price might drop once the company s successful bid is announced. Alternatively the share price might rise once the successful bid is announced if the market views this as a good investment. If the market is unsure of whether this is good or bad news the uncertainty is likely to result in a fall in the share price. That will be a temporary reaction to the uncertainty created by the project and the price will stabilise once the market has worked through whether this is a good investment or not.

The best way to minimise this uncertainty is to keep the markets as fully informed as possible. That might be difficult given the need for commercial sensitivity. Ideally, the directors should brief the major investors prior to the result of the bid being announced. The markets will then factor in an amount (but not the full announcement of bid result amount) for the possibility that the company s bid is successful.

The performance in this question was disappointing given results in similar questions in previous diets. Candidates should ensure that they understand the logic behind this topic.

17 (i) The compensation is a liability of Insurance (Accident) Ltd. Its holding company has no specific duty to make good any default by any member company. There is no legal advantage in being owed money by a company that happens to be part of a large group. It would be possible to ask for a formal guarantee from the holding company. That would create a contract that would be binding in the event of default. There is also the commercial reality that the holding company would suffer adverse publicity if it permitted a group member to collapse leaving unpaid creditors. It is very possible that the group would make good any failure by Insurance (Accident) Ltd as a goodwill gesture. You should not accept this reassurance without obtaining legal advice.

(ii) (a) The goodwill on acquisition is very much a technical accounting adjustment that reflects differences between the amount paid for a subsidiary and its balance sheet valuation according to accounting


Examiners Report

Page 6

standards. As an asset it has no separate existence outside of the group accounts and even its initial valuation might not reflect the true value of the investment in the subsidiary (e.g. it could have been purchased at a low price because of sound bargaining). The asset cannot remain a permanent entry in the consolidated financial statements because the factors that led to its initial recognition will change rapidly, rendering its value out of date. It is written off in order to eliminate it from the bookkeeping records, but that does not imply any lack of commitment to maintaining its value. The alternative to writing it off would be to revalue each and every group member on an annual basis and restate goodwill to reflect the underlying worth of the businesses. Such a treatment would be impractical because of the difficulties of valuing companies in any kind of objective manner. There is no direct implication for the value of your investment.

(b) Many of the figures in the financial statements require some estimates or assumptions in order to determine them. Failure to include such figures would leave substantial gaps in the accounts. Very few figures, other than bank or cash, are strictly accurate. Most readers are aware of this and take it into account when reading the annual report.

In general, the estimates and assumptions are likely to fall within realistic ranges and so there is little scope for massive manipulation or error. For example, an insurance company will have substantial experience of determining the likely outcome of pending claims. Those involved in the reporting process will take care to ensure that this expertise and experience is put to good use.

(c) The directors are subject to the provisions of the accounting standards published by the accountancy profession , the relevant rules and regulations contained in legislation and possibly other rules such as those laid down by the stock exchange. The directors are legally responsible for ensuring compliance with these requirements and would suffer public criticism if they were later found to have manipulated them. The financial statements also carry an auditor s report. The auditor is responsible for expressing an opinion on the truth and fairness of the accounts and is subject to various professional and statutory duties to ensure that this responsibility is discharged correctly.

Performance in this question was notably weak. This was largely due to a failure to read the question s requirements. The case material provided was intended to support candidates, but many appeared to have been confused by it. This was essentially a straightforward question that tested an understanding of the key accounting statements.

END OF EXAMINERS REPORT


EXAMINATIONS





1. Enter all the candidate and examination details as requested on the front of your answer booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the supervisor.


4. Attempt all 17 questions. From question 11 onwards begin each answer on a separate sheet.



Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this question paper.

In addition to this paper you should have available Actuarial Tables and your own electronic calculator.

Faculty of Actuaries 108 S2004 Institute of Actuaries

108 S2004 2

For questions 1 10 indicate in your answer book which one of the answers A, B, C or D is correct.

1 What is the main purpose of charging depreciation in the accounts of a business?

A To ensure that funds are available for the eventual replacement of the asset.

B To reduce the cost of the asset in the balance sheet to its estimated market value.

C To allocate the cost of the fixed asset over the accounting periods expected to benefit from its use.

D To show the fixed asset at its true value to the business. [2]

2 A company has ranked four mutually exclusive projects, each requiring an equal initial investment, using four different criteria. Each criterion identifies a different project as best. Which project should the company select?

A The project with the highest internal rate of return. B The project with the highest net present value. C The project with the highest surplus over annual capital. D The project with the shortest payback period.

[2]

3 Z plc has just published its financial statements, which show a gross profit for the year of £7.5 million. A major error in the stock valuation has just been discovered. The opening stock is overstated by £0.8 million, and the closing stock has been understated by £1.2 million. What should be Z plc s correct gross profit for the year?

A £5.5m B £7.1m C £7.9m D £9.5m

[2]

108 S2004 3 PLEASE TURN OVER

4 Rights issues are normally associated with a decrease in the share price immediately following the issue. Which of the following is the most likely reason for this?

A The market will be uncertain about the merits of the investment that is to be funded by the issue.

B The new shares are issued at a discount to their current market value.

C The use of a rights issue implies a lack of confidence on the part of management.

D Rights issues involve substantial professional fees and other expenses. [2]

5 Which of the following best describes the purpose of an external audit of financial statements?

A The auditor advises on accounting matters.

B The auditor ensures that the company s financial statements comply with all relevant legislation.

C The auditor expresses an opinion on corporate governance matters.

D The auditor expresses an opinion on the truth and fairness of the financial statements.

[2]

6 A company must raise finance in order to acquire a piece of machinery. Which of the following is likely to be the least appropriate form of finance for this purpose?

A Borrow the cost of the machine from a bank.

B Lease the machine from a finance company.

C Purchase the machine by cheque, increasing the company s overdraft by the cost of the machine.

D Purchase the machine on hire purchase from the manufacturer. [2]

108 A2004 4

7 Y plc has a high price earnings ratio. Which of the following best describes the market s opinion of Y plc?

A High risk and expectations of strong future growth. B High risk and expectations of weak future growth. C Low risk and expectations of strong future growth. D Low risk and expectations of weak future growth.

[2]

8 Which of the following defines a limited company s relationship with the outside world?

A Annual report and accounts B Articles of association C Memorandum of association D Share certificates

[2]

9 Which of the following organisations is responsible for the issue of Treasury bills?

A Gilt-edged market makers B The Bank of England C The Debt Management Office D The Financial Services Authority

[2]

10 A company owns 30% of the ordinary share capital of another. Which of the following is most likely to be the correct description of the investment in the first company s balance sheet?

A An associate company B A fixed asset investment C An intangible asset D A subsidiary company

[2]

11 Explain the role of simulation as an element of appraising an investment project. [6]

12 Explain the role of investment trusts as vehicles for investors. [8]

13 Explain the purpose of consolidated financial statements. [6]


14 V plc is a quoted company. The directors are discussing the final dividend for the year ended 31 December 2004. The company has recently been forced to make a series of structural and financial changes. Even though the financial year has not yet ended, it has become apparent that the company will not be able to pay the same level of dividend as in previous years.

Explain how the directors should proceed if they decide to reduce the dividend temporarily and explain the possible implications for the company s share price.

[10]

15 Many equity investment decisions made by individual investors are affected by tax considerations. Some equities offer greater potential for income while others are more likely to generate capital growth. Explain how the UK tax system differs between its treatment of dividend income and capital gains and explain which form of return is likely to be the more tax efficient for investors. [10]

16 The Marco family own 100% of Marco Trading Ltd, a major company that has been established for many years. The directors, all members of the family, are considering floating the company on the London Stock Exchange.

(i) Identify the matters that the directors and shareholders of this company ought to consider in deciding whether to seek a flotation and explain the importance of each. [10]

(ii) Assuming that the company does decide to proceed with the flotation, describe the major decisions that will have to be taken by the directors of the company.

[10] [Total 20]

108 A2004 6

17 H plc manufactures household appliances. Most of its purchases are of generic parts and materials that are widely available. H plc has a policy of developing a very close working relationship with one supplier for each category of material and relying heavily on that supplier to deliver in quantities and at times that enable H plc to meet its manufacturing deadlines without carrying a great deal of stock.

H plc is looking for a new supplier of light sheet steel. It has obtained the financial statements of two possible companies, each of which can supply steel of the necessary quality for an acceptable price. H plc s chief buyer is comparing the financial statements of both companies to identify the one which is at least risk of becoming insolvent. The statements have been summarised below:

Profit and loss accounts

for the year ended 31 August 2004

P Ltd

Q Ltd

£000

£000

Sales 2,900

1,800

Operating expenses 2,030

1,460

Earnings before interest and tax 870

340

Interest 16

44

Tax 370

280

Ordinary dividend 120

12

Preference dividend 72

Retained for year 292

4


Balance sheets

as at 31 August 2004

P Ltd

Q Ltd

£000

£000

Tangible fixed assets 3,800

1,210

Current assets

Stock 40

34

Debtors 238

170

Bank 5

7

283

211

Current liabilities

Creditors 190

160

Proposed dividend 96

6

Tax 350

270

636

436

Net current liabilities 353

225

3,447

985

Loans 200

400

3,247

585

Ordinary share capital 1,000

300

Preference share capital 900

Retained profit 1,347

285

3,247

585

P Ltd owns its factory premises. Q Ltd rents a factory unit, paying £200,000 per annum in rent.

108 A2004 8

Requirements

(i) Calculate the following ratios for each of the above companies:

(a) Gearing (b) Interest cover (c) Current ratio (excluding tax from current liabilities)

[6]

(ii) Identify the company which is at greatest risk, referring to the ratios that you calculated above. You should also refer to any other relevant information contained in the question. All of Q Ltd s tangible fixed assets are in the form of plant and equipment. [12]

(iii) Explain why the tax liability was excluded from the current ratio in the above comparison. [2]

[Total 20]

END OF PAPER


EXAMINATIONS

September 2004


EXAMINERS REPORT


Subject 108 (Finance and Financial Reporting) September 2004

Examiners Report

Page 2

1 C 2 B 3 D 4 B 5 D 6 C 7 C 8 C 9 C 10 A

The objective test questions were generally answered well, with no particular problems arising.

11 Projects are often too complex or too uncertain to analyse using conventional means. Cash flows might be subject to a host of different assumptions. Discount rates or beta coefficients might also be subject to some uncertainty. Simulation provides a means of sensitivity analysis to enable management to see whether altering key variables is likely to have a profound effect on the outcome of the project. In an ideal world, the simulation will indicate that the expected outcome of the project is robust even when several aspects of the decision vary.

Simulation makes it possible to model the effects of changing estimates and assumptions. A model can be built that allows for relationships between these (e.g. links between exchange rates and interest rates). A probability distribution can be modelled for the remaining independent variables and a series of outcomes can be generated using a range of inputs possibly biased towards the most likely or the most pessimistic depending on the nature of the decision and its importance to the company.

This question was looking for an understanding of the role of simulation. Generally answers were correct in factual terms, but often failed to make the link to investment.

12 Individual shareholders might not have the necessary wealth to enable them to diversify their investment portfolios. Investment trusts enable them to make a single investment in one company and to have that investment spread across a range of shares. Investment in an investment trust may also entail the purchase of the underlying assets at a discount to their net asset value. The investment trust managers will also be expert investors. Investing in an investment trust might be a cheaper means of obtaining such expertise than would be offered by an investment adviser.

Individual investment trusts have different investment policies, offering a choice between different profiles of risk and return. Investors should be able to find a fund that balances their need for stability against their desire for higher gains. Some investment trusts are geared to providing capital growth, whereas others focus on


Examiners Report

Page 3

income, so investors can choose accordingly depending on their circumstances and their tax position.

Investors might want to invest in particular niche areas, such as specific industries or markets. Even larger investors might not have the necessary expertise to invest in, say, the Japanese market. Some investment trusts specialise in very focussed areas and so it should be possible to find a trust that can plug a gap in a portfolio.

Investment trusts are not ideal investments for everybody. Some investors will have both the means and the expertise to manage their own portfolios. Investing through an investment trust will involve management charges that could be avoided. Some investors will have very specific needs for flexibility and access to their funds. Investment trust investments will generally be suitable for those who intend to buy and hold for a considerable period.

This question was looking for knowledge of the particular institutional issues raised. Answers were surprisingly weak, with relatively few full answers.

13 Large companies, including quoted companies, are often organised as groups. Consolidated financial statements reflect the economic reality of the group structure. Groups have no specific legal identity. Technically, they comprise independent companies operating under the common control of a holding company. Groups do, however, have an economic identity. Almost by definition, the directors of the holding company can control the affairs and manage the assets of each of the group members. Consolidated financial statements present the economic reality of this group arrangement by combining the figures of the individual group members in such a way as to eliminate internal balances and combine the remaining figures as if they were under one common management.

If there were no consolidated financial statements then investors in holding companies would have no convenient means of understanding how their investments were being managed by their directors. The process of consolidation enables shareholders to see how their investments are being managed in terms of real, economic activities.

This question was looking for an appreciation of the nature of consolidated financial statements. Answers were generally sound, although many candidates did not attempt the question.

14 The stock market is likely to interpret any change in the dividend policy as a very clear message about the directors confidence in the company s future. The decrease will almost certainly create doubts and uncertainties and the directors should take the greatest possible care to minimise these. The company should give the markets as much warning as possible about the decrease. That announcement should be supported by the clearest possible indication that this is a temporary measure intended to get the company through a period of change. The directors will have to take care that this information is distributed in a manner acceptable to the stock exchange because it is clearly price-sensitive. It would be advisable to brief analysts and other key investors in greater detail so that they are less likely to undermine public confidence in the company s recovery.


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There is no doubt that the share price will fall as soon as the announcement is made. This is partly because the markets will regard the reduction in dividend as a more reliable signal than the directors assurances. Some shareholders will choose to sell because the suspension of the dividend will affect their personal liquidity. The laws of supply and demand will push down prices. In the medium to long term the price will rise again and, hopefully, return to its previous level. The share price will always be a function of the market s expectation of future earnings and dividends. Once the markets see that the directors promises about the future are genuine then the uncertainty that depressed the share price will be eliminated.

This question brings together issues about dividend policy and the behaviour of capital markets. It tended to polarise candidates, with some very full and thorough answers and others that were either thin or had missed the point.

15 Investment income from equities normally takes the form of franked investment income. That is the amount of any net dividend received plus an associated tax credit. The tax credit is then deducted from the resulting tax liability in order to reflect the fact that the company has already paid corporation tax on the profits that provided the means to pay the dividend. Basic rate taxpayers will not pay any additional tax as a result of the receipt of franked investment income, but higher rate taxpayers will be required to pay additional tax.

Investors have no discretion about the timing of the receipt of their dividend income and are taxed in the year in which the income is received.

Capital gains are taxed separately from dividend income. Individuals have a separate annual allowance for capital gains. The gains themselves are not taxed in the year in which the gain arises but in the year in which it is recognised. Thus, an investor could delay the timing of a disposal in order to delay a gain until a more suitable tax period. The gains themselves are subject to a tapering allowance which counters the effects of rising prices.

Higher rate taxpayers will often find that capital gains are taxed in a less onerous manner than income.

This question was generally answered well, with most candidates being aware of the broad differences in the tax treatments of income and capital gains.

16 (i) The company cannot be listed unless a significant proportion of the shares are in public hands. This means that the family will have to make significant sacrifices in terms of control over their business.

Decision making will be far more formal and complex because it is no longer a matter for family discussion. Outside shareholders will probably want a significant change in the composition of the board to ensure that the family s interests do not drive the direction of the company.

There will be substantial costs associated with the flotation and these will effectively be borne by the family. There are also ongoing reporting costs and compliance costs associated with listing.


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Outside shareholders will not have the same long-term commitment to the company as members of a family.

The flotation would open up the prospect of significant external equity. That might make it possible for the company to expand rapidly. However, the company may also become more open to an unwelcome takeover.

There will be an objective market price for the shares and this will make it far easier to value any shares that are sold or given to a family member.

Any member of the family who is not happy will be able to leave and liquidate his/her shareholding.

(ii) The directors will have to decide on the timing of the flotation. Ideally, this will be at a time when the business is likely to be viewed as successful.

There are different levels of quotation. A quote on the main exchange will be more expensive, but will carry more prestige. A quote on one of the alternative markets will be simpler, but might not offer as many advantages. The directors may wish to consider whether London is the most appropriate stock exchange for the company, or whether a better alternative would be found overseas.

The method of introducing the shares will have to be considered. For example, the company could sell additional shares on the open market (and dilute existing shareholdings) or it could sell existing shares on behalf of the family members.

The asking price will have to be decided. Too high a price will make the sale flop while too low a price will dilute the family s wealth.

The company will have to select professional advisers to manage this process.

Depending on the manner in which the shares are to be made available to the market, the directors will have to decide on whether to underwrite the transaction. Doing so will reduce risk, but will also incur substantial fees.

Again, this question was answered well, with most candidates being aware of the implications of a flotation.

17 (i) P Ltd Q Ltd

Gearing 900 2003, 247 200

32% 400585 400

41%

Interest cover 87016 72

9.9 times 34044

7.7 times


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Current ratio 283286

1.0:1 211

166

1.3:1

(ii) Q Ltd appears to be at greater risk in terms of gearing and interest cover. This means that Q Ltd is more vulnerable to any fluctuation in operating profits. Q Ltd s fixed outgoings are proportionately higher than P Ltd s. Any decrease in turnover will put the company at greater risk of failing to meet an interest payment or loan repayment.

The above comparison actually overstates P Ltd s vulnerability relative to Q Ltd s. Much of P Ltd s fixed interest capital is in the form of preference shares. In the event of a downturn in business, it should be possible for P Ltd to suspend dividend payments to the preference shareholders. It is also unlikely that the preference shareholders will be entitled to the repayment of their investment or that they can force P Ltd into liquidation in the event that any scheduled repayment is delayed.

Q Ltd s gearing is also understated in the sense that the company rents its premises. The nature of the rental agreement does not appear to require disclosure as a finance lease, but the need to pay rent on this factory or a replacement creates a very similar commitment. If Q Ltd s factory rent was treated as a finance charge then earnings before interest and tax would increase to £540,000 and interest to £244,000. That would reduce Q Ltd s interest cover to 2.2 times.

The fact that P Ltd owns property will also make it easier for the company to secure a loan in order to weather any temporary cash crisis.

P Ltd has a poorer current ratio. That increases the risk of the company running out of cash in the short term. That is, however, a less serious threat than that created by Q Ltd s high gearing because P Ltd could borrow more easily to obtain long term working capital. It would also be relatively easy for H plc to make a small payment in advance to P Ltd in order to resolve any short-term difficulties.

(iii) The current ratio measures a company s ability to meet its immediate liabilities. The tax liability is not an immediate liability because it does not have to be paid until several months after the year end. There is no need to worry whether the company has sufficient cash to meet this liability as at the year end provided it has the capacity to raise funds before the due date.

Answers to this question were disappointing, with too many answers consisting of little more than a computation of ratios. Also, the question had some quite specific requirements about the issues that were to be raised in the analysis. Many candidates wasted time on the provision of ratios that were irrelevant to the question.

END OF EXAMINERS REPORT

108 finance and finance reporting (actuarrial)

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