CT2 PXS 14

CT2 P XS 14
Series X Solutions
ActEd Study Materials: 2014 Examinations

Subject CT2
Contents
Series X Solutions
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CT2: Assignment X1 Solutions
Page 1
Assignment X1 Solutions
Answers to multiple-choice questions
The following table gives a summary of the answers to the multiple-choice questions.
The answers are repeated below with explanations.
1
10
Solution X1.1
Answer = B
A and C are basic principles of taxation. D is a description of corporation tax. The
marginal rate of tax is the proportion of an additional of income that is taken in tax.
This can increase with income, eg income tax in the UK. However, some taxes are
unrelated to income, eg a poll tax. In this case, a 1 increase in income does not cause
any increase in tax and therefore the marginal rate of tax is zero.
[2]
Solution X1.2
Answer = B
Only a public limited company must have an issued share capital of at least 50,000. [2]
Solution X1.3
Answer = C
The effective conversion price is the price per share that you (effectively) pay by buying
the convertible and then converting it.
[2]
Page 2
Solution X1.4
Answer = B
Marketability and credit risk are the key differences between government bonds and
loan stock which are of concern to investors. The size of a bond issue affects its
marketability. (The accrued interest basis of taxation applies to corporate loan stocks as
well as to government bonds.)
[2]
Solution X1.5
Answer = B
This is the definition of a floating-rate note.
[2]
Solution X1.6
Answer = D
The question says that the security for the loan can be changed by the borrower. This
refers to a floating charge, rather than a fixed charge.
[2]
Solution X1.7
Answer = C
Principal-agent problems arise when there is a conflict of interest between the principal,
eg the shareholder and the agent, eg the manager. These conflicts can be reduced by
incentives to encourage the managers to work in the interest of the shareholders, eg by
executive share options and profit-related bonuses, and by having written agreements
setting out the roles and responsibilities of all the stakeholders. Performance-related pay
would be a greater incentive for workers and managers to strive to increase profits than
payment by the hour.
[2]
Page 3
Solution X1.8
Answer = B
The buyer of an option does not have an obligation and therefore cannot have a liability
at expiry. In the other cases the investor may have an obligation to settle. The writer of
a call may find that he has sold someone the right to buy stock from him at a price
below the current market price. In the case of the seller of a futures contract, he may be
obliged at expiry to sell a bond at a price that is below the then current market price. In
the case of the owner of a futures contract, he may be obliged to buy a bond at a price
that is then above the current market price.
[2]
Solution X1.9
Answer = C
The financial manager aims to maximise shareholder wealth (or the share price) by
investing in projects that display a positive net present value when discounted at the
(opportunity) cost of capital. We do not discount at the cost of borrowing, but at the
rate that shareholders and debt holders could have received on equivalent alternative
investments.
[2]
Solution X1.10
Answer = D
The theoretical share price after the scrip issue is:
(4 3) + (1 0)
5
4
(3) = 2.40
5
A scrip issue brings no new capital into the business, thus the total share capital and
reserves must remain at 150,000. However, the share capital will increase and the
reserves will fall. The share capital was originally 100,000 (400,000 shares @ 25p)
and is now 125,000 (500,000 shares @ 25p); and the reserves were 50,000 and are
now 25,000.
[2]
Page 4
Solution X1.11
Course Reference: Chapter 1.
Shareholders will benefit from higher profits if the company successfully pursues risky
projects, and so may wish the company to undertake risky projects in pursuit of these
returns.
[1]
Other stakeholders, including debtholders and the directors and employees of the
company, may see little benefit if risky projects succeed but suffer significant
consequences if they fail, and so may be less keen for the company to pursue risky
ventures.
[1]
Shareholders are generally concerned with maximising profit and seeing a rising share
price and so may aim to minimise costs, eg through implementing more efficient
technology or outsourcing some tasks.
[1]
Employees however might be concerned that such actions result in their jobs being lost
or their terms and conditions of employment deteriorating.
[1]
The local community and government might be concerned about the effect of the
companys policies on the physical and economic environment, eg traffic noise and
congestion, various forms of pollution, contributing appropriately to the countrys tax
revenue.
[1]
In order to maximise profits and dividends, the shareholders may be less concerned with
these impacts, preferring not to incur the costs associated with production methods that
have minimise environmental impact and looking to exploit tax minimising
opportunities.
[1]
[Maximum 5]
Markers, please give credit for other appropriate examples
Page 5
Solution X1.12
Advantages
The major advantage of the limited company is that its limited liability status makes it
much easier for the organisation to raise money from investors. People may be
reluctant to become involved as a part owner of a partnership since they risk their entire
personal wealth. With limited liability people are likely to be much more willing to
provide capital.
[1]
This is particularly important for business ventures involving a risk of incurring
substantial debts (such as insurance companies), and businesses which require large
amounts of capital (such as large industrial firms).
[1]
Limited liability allows large numbers of people to invest small amounts of money with
relatively minimal checking of the companys prospects. Investors can have
shareholdings in a wide range of companies thus spreading their risk.
[1]
The board of directors can choose to hire professional managers to run the company.
This use of specialists should increase efficiency.
[1]
The separation of owners and managers allows ownership to change without affecting
management.
[1]
Limited companies have to abide by the Companies Act and (if they are over a certain
size) produce audited accounts, thus leading to greater transparency and greater
credibility than other types of businesses.
[1]
Disadvantages
The main disadvantage of limited companies is for the creditors of the company
following a winding-up. Once the companys assets have been exhausted, the trade
creditors have no way of ensuring payment.
[1]
Ownership of the business is often divorced from day-to-day control, which may
encourage an inefficient corporate attitude to develop. The managers of a company may
have aims that are not in the best interests of the shareholders. This is an example of the
agency problem.
[1]
Similarly, limited liability allows people to invest in shares without taking an active
interest in the long-term needs of the company, because they are more interested in
short-term dividend prospects.
[1]
Page 6
Information asymmetries often exist between various classes of stakeholder (managers,

workers, shareholders, debt holders etc), ie the different stakeholders have access to
different information. This makes any agency problem more difficult to resolve. It also
reinforces the need for proper accounting standards to be observed.
[1]
A company is more expensive to establish and run than other forms of business.
[1]
[Maximum 8]
Solution X1.13
Double taxation relief is intended to reduce the extent to which individuals and
companies are taxed twice on the same income.
[1]
Double taxation relief is available on income and capital gains.
[1]
Tax paid overseas on overseas income can be offset against the liability to domestic tax
on that income or capital gain.
[1]
The maximum offset is the rate of tax that would have been paid locally on the grossedup income.
[1]
For example, if a UK company has to pay 30% corporation tax and has paid 20% tax on
its profit made in India then it will have to pay the additional 10% in the UK. If it has
paid 40% tax on its profit in Norway, it pays no more tax in the UK. It cannot reclaim the
additional tax paid in Norway.
[1]
[Maximum 4]
Page 7
Solution X1.14
Non-recourse factoring is where a supplier sells on its trade debts to a factor in order to
obtain cash payment of the accounts before their actual due date. The factor takes over
all responsibility for credit analysis of new accounts, payment collection and credit
losses.
[1]
With recourse factoring, the supplier still receives a cash payment up front from the
factor, but the supplier retains responsibility for collecting the debt. Once the debt is
collected, the amount of the debt is paid over to the factor.
[1]
Advantages of non-recourse factoring for Country Dairy Ltd:
The administration of debt collection would be undertaken by the factor. This

may be useful for a small business where there are few (if any) dedicated
accounts staff.
[1]
The factor takes all of the credit risk. This would help make cashflow more
predictable.
[1]
Advantages of recourse factoring for Country Dairy Ltd:
Recourse factoring would be cheaper than non-recourse factoring. If Country

Dairy Ltd is short of cash, it may be very price sensitive.
[1]
All contact with customers will be through Country Dairy Ltd rather than the
factor. For a small business, maintaining amicable relations may be very
important.
[1]
[Maximum 5]
Solution X1.15
The company could agree today to buy the currency at a fixed exchange rate for
delivery at the time the currency will be required. This would be in the form of a
forward contract under which both parties would exchange the amounts of currency on
the expiry date.
[1]
Alternatively, the company could buy sufficient currency futures contracts to hedge the
exposure. These contracts would be organised by an exchange and would be cashsettled through margin payments rather than delivered.
[1]
Page 8
The hedges mitigate the currency risk because:
if the overseas currency rises relative to the domestic currency, the extra costs of
buying the currency to finance the project will be offset by the profit on the
contracts.
if the overseas currency falls relative to the domestic currency, the company will
make a loss on the contracts but it will be cheaper to finance the project.
[1]
Effectively, the company locks in to a known exchange rate, as neither hedge allows the
company to benefit from favourable movements in the exchange rate.
[1]
(A call option would give the company the right but not the obligation to buy but with a
premium cost.)
Both strategies can only be carried out if the amounts and timings of currency required
can be accurately estimated in advance. This is not always the case, and approximations
must be used.
[1]
The use of futures contracts allows the company to reduce the amount of the hedge in
the light of revised forecasts. In contrast, forward contracts will be delivered (assuming
the counterparty does not default). The company will have to open new forward
contracts, selling the overseas currency, if the amount of the hedge is to be reduced. [1]
The forward contract would be tailor-made whereas the futures contract is standardised
by the exchange, so the company would only be able to buy standard amounts of the
currency.
[1]
If the company has foreign currency income, it may have a natural hedge for its foreign
currency costs. In practice, it is likely that the income will be received much later than
the costs will be incurred.
[1]
[Maximum 5]
Page 9
Solution X1.16
(i)
Theoretical ex-rights share price
Number of issued shares before the rights issue:

8m
= 16m
0.50
Current share price:
60m
= 3.75
16m
[1]
Rights issue price = (1 20%) 3.75 = 3.00
[1]
Theoretical ex-rights share price:

4 3.75 + 1 3.00
= 3.60
5
[1]
[Total 3]
(ii)
Why actual ex-rights price is likely to differ from this theoretical price
The company will incur expenses in undertaking the rights issue, eg in advisor fees and
communicating with shareholders, that will reduce the net worth of the company and so
result in a lower ex-rights share price.
[1]
The actual price will depend on the market reaction to the rights issue, as measured by
supply and demand. If the rights issue is not fully taken up, the actual share price might
be lower than the theoretical price.
[1]
Market reaction to a rights issue may be negative if the perception is that the rights issue
is being undertaken because the company is in trouble and needs the capital to ensure
survival.
[1]
However, market reaction to a rights issue may be positive, eg if it is to raise capital for
a new project or expansion that is seen as a good thing.
[1]
Any news that emerges about the company in the period between the rights issue being
announced and the issue occurring will have an impact on the actual ex-rights price. [1]
Page 10
The actual share price will also be affected by more general sector wide or equity
market wide movements in share prices during this period.
[1]
[Maximum 5]
(iii)
Factors the directors should take into account in the underwriting decision
The main advantage of underwriting is that it removes the risk of the company being
left with unsold shares, so the directors should assess how likely this risk is to occur.
For example, this may depend on the general prospects for the stock market.
[1]
The company should discuss the likely market perception of the issue with independent
experts and advisors such as the companys investment bank.
[1]
The rights issue is more likely to be successful if the new shares are sold at a larger
discount so the directors should consider whether the proposed 20% discount is
sufficient to ensure a fully-subscribed issue.
[1]
While a discount is likely to make the shares attractive, the expected volatility of the
stock market and of the company itself should also be considered. If the share price is
likely to move rapidly then the rights price could exceed the market price, thereby
making the new shares unattractive.
[1]
The reason for raising the capital is itself a factor influencing the need for underwriting.
If the company has a project that the market finds attractive, then the share price could
rise in response to that information and that will make the rights issue even more
attractive, thus mitigating the need for underwriting.
[1]
The directors should also consider the consequences of the issue not being fully
subscribed, eg the company may have insufficient funds to finance any project for
which the shares were being issued, leading to the project being unable to go ahead or
additional long term finance needing to be raised by some other means.
[1]
The directors should consider the likely fees payable to underwriters and assess these
costs against the benefits of underwriting.
[1]
[Maximum 5]
Page 11
Solution X1.17

(i)
Reasons for seeking a listing
A listing allows the company to sell new shares to a wide market and so to raise capital
at the point of listing (as the company is likely to choose a method of obtaining a listing
that raises capital).
[1]
A listing will also make it easier to raise additional equity finance in future and make it
easier to raise short- and long-term debt finance, because lenders feel safer and happier
about lending money to a listed company (since it has to meet the exchanges initial and
on-going requirements).
[1]
Listing on a stock exchange will give existing shareholders an exit route, eg venture
capitalists who supported the company in its early years and wish to realise their
investment.
[1]
A listing makes the companys shares more marketable and more accurately and easily
valued.
[1]
This increases the attraction of holding the shares, eg it enables shareholders to use the
shares as backing for their own borrowing and enables XYZ to offer its shares to
shareholders in a target company in a takeover bid.
[1]
A listing will also make employee share participation and/or director share option
schemes more attractive.
[1]
Listing may improve the status of the company and increase public awareness of the
company leading to increased sales.
[1]
[Maximum 5]
(ii)
Disadvantages of obtaining a listing (for existing shareholders)
Any cost that the company incurs in obtaining a listing (both initial cost and on-going
cost associated with meeting the continuing obligations) is likely to reduce the returns to
its shareholders.
[1]
As 25% of the shares must be in public hands, the existing shareholders may see their
control over the company reduced.
[1]
A listing will make an unwelcome takeover harder to avoid.
[1]
Page 12
These disadvantages are particularly relevant if the company is current owned by a

small number of people, eg if it is a family-owned business.
[1]
[Maximum 3]
(iii)
Relative attraction of various issuing methods
Offer for sale (at a fixed price)

In an offer for sale at a fixed price, a predetermined number of shares is offered to the
general public at a specified price via an issuing house.
[1]
This is the most common and widely understood method for large issues and is the most
likely to attract a wide range of shareholders.
[1]
The fixed price and the underwriting by the issuing house result in the amount to be
raised being known in advance, enabling XYZ to plan its use of the capital with
confidence.
[1]
As well as underwriting the issue, the issuing house advises the company about the
timing and the pricing of the issue and oversees the whole issue.
[1]
Although XYZ will need to pay the issuing house a fee, this fee may be lower than that
for an offer for sale by tender, as a fixed price offer is less complex to administer and
the allocation process is less complex.
[1]
An offer for sale (either at a fixed price or by tender) may be a requirement of the stock
exchange on which XYZ is seeking a listing.
[1]
Offer for sale (by tender)
An offer for sale by tender is similar to an offer for sale at a fixed price but the issuing
house invites applicants to submit a tender stating the number of shares that they are
prepared to buy, and the price that they are prepared to pay.
[1]
If the offer proves popular in the market then this method may raise more capital for
XYZ than an offer for sale at a fixed price.
[1]
The strike price will be set in the light of the level of demand for shares and can, if
necessary, be set lower than intended in order to place all the shares. Therefore the
costs of underwriting may be lower.
[1]
Page 13
Offer for subscription

Subscriptions are similar to offers for sale (at a fixed price or by tender) however, the
issuing company sells shares directly to the public and bears (at least part of) the risk of
undersubscription.
[1]
An offer for subscription should be cheaper to arrange than the other methods of issue
because the company issues the shares directly to the public without the help of an
issuing house (although it may hire an issuing house as an adviser).
[1]
Placings (selective marketing)
With a placing, an issuing house first buys the securities from XYZ and then
individually approach institutional investors such as pension funds and life offices
directly to purchase the shares.
[1]
This is the simplest method, and is the most common method for small issues, and so
administration and marketing fees should be low.
[1]
As with an offer for sale at a fixed price, the fixed issue price means that the amount to
be raised is known.
[1]
[Maximum 12]

the course.
Page 1
1
10
Solution X2.1
Answer = B
Profit is not the same as cash, so C is true. Sales being on credit terms is one example
of why profit is not the same as cash, so A is also true. Preference dividends come after
tax, but before ordinary dividends, so D is true.
[2]
Solution X2.2
Answer = C
As depreciation is calculated using the reducing balance method, we need to find r,
where:
r 1 (5,000 / 70,000) 0.1 = 23.195%
After one year, the value of machinery shown under non-current assets will be:
70,000 (1 0.23195) 53,763
[2]
Page 2
Solution X2.3
Answer = C
Receipt of unfranked investment income is not a reason this income, eg interest on
loan stock, is taxable at 30%. Receipt of franked investment income, eg dividends on
ordinary shares, may be taxed at a lower rate.
If the company has business expenses in its accounts that are no allowable for tax, then
adding these expenses back in to determine the companys taxable profit will result in an
effective tax charge ratio greater than 30%.
Capital allowances serve to reduce taxable profits to reflect the usage of non-current
assets. If the rate is greater than the rate at which the company is depreciating the asset
then the taxable profits will be less than the published profits. Hence the tax charge will
be lower than expected.
Overseas income will be taxed in this country if the rate of tax paid overseas is less than
30%. Double tax agreements will not reduce the rate of tax below 30%; they can only
stop the total tax charge exceeding 30%.
[2]
Solution X2.4
Answer = D
Before the issues the company had 1m shares and was worth 5m in the market.
Following the issues the company has 2.2m (21 + 0.2) shares and was worth:
5.4m (5 + 0.22).
Therefore each share is now worth 2.45 (5.4 2.2).
Alternatively, you could find the new price as a weighted average of the share price after
the scrip issue and the rights price:
(10 2.50) + (1 2)
= 2.45
11
[2]
Page 3
Solution X2.5
Answer = A
A cashflow statement is not actually required by the Companies Act, though it is regarded
as good practice to produce one and is a requirement for companies who are obliged to
use international accounting standards.
[2]
Solution X2.6
Answer = C
IAS 8 states that in the absence of a specific rule to specify an appropriate accounting
policy, the company should select policies on the basis that they yield information that is
both relevant and reliable. Information is defined as relevant if it informs decisions taken
by users of the financial statements.
[2]
Solution X2.7
Answer = A
An increase in trade payables, eg credit offered by trade suppliers, improves the
companys cash position.
[2]
Solution X2.8
Answer = C
Trade payables are a liability of the business. The business owes trade suppliers money
for supplies received.
[2]
Solution X2.9
Answer = B
Dividends are a payment out of earnings and reduce the amount retained in the business.
Equity includes share capital and reserves. Reserves include share premium, revaluation
reserves and retained earnings.
[2]
Page 4
Solution X2.10
Answer = C
Debit items include cost items from the income statement and assets from the balance
sheet. Credit items include revenue from the income statement and capital and liabilities
from the balance sheet. Cash is an asset and therefore a debit item. A long-term loan is a
liability and therefore a credit item.
[2]
Solution X2.11
The aim of the materiality concept is to make the accounts more user-friendly.
Information should be provided if it is important to the readers understanding of the
companys position.
[1]
The usefulness of the statements is not improved by providing information which is too
detailed. The statements can, therefore, be made more useful by showing totals such as
administrative expenses or salaries instead of listing every item which makes up
these headings.
[1]
Also, there is very little point in making small adjustments which have no real effect on
the picture portrayed by the financial statements. So the materiality concept might
permit approximations for certain costs rather than requiring more precise figures. [1]
What is, or is not, material however does depend to some extent on the emphasis which
the company will put on the relevant figures, not just the size of the figures.
[1]
The key issue is whether the extra disclosure would help the reader of the statements get
a better view of the company. So, for example, a relatively small regulatory fine,
though a small financial amount, would still be material.
[1]
Also, certain salaries would be disclosed separately, possibly in the notes to the
financial statements. For example, directors salaries might be disclosed separately. [1]
The additional costs of producing financial statements without using the materiality
concept (both the costs to the company, the auditors, and the users of the accounts in
interpreting the information) would be significant and may not bring any benefits.
[1]
[Maximum 5]
Page 5
Solution X2.12
Definition and purpose of depreciation
Depreciation is a measure of the wearing out or using up or other reduction in the useful
life of a non-current asset.
[1]
This can occur because of the passage of time (eg a lease), because of usage (eg a
machine) or because of changes in technology or market conditions (eg computers). [1]
Depreciation is charged to the companys income statement each year to write off the
amount paid for the asset over the useful life of the asset.
[1]
It is an application of the matching principle in that it is an attempt to match the revenue
earned in an accounting period to the costs incurred (in this case, from the use of a noncurrent asset) in earning that revenue. It is not an attempt to reflect the value of the noncurrent assets in the balance sheet.
[1]
Depreciation methods
The two main methods of depreciation are the straight line method and the reducing
balance method.
As an example, let us assume a vehicle is purchased at a cost of 20,000, and will have
a residual value of 2,000 after ten years.
Using the straight line method, the annual depreciation charge is the same amount each
year.
[1]
The annual figure for depreciation is found as follows:
Depreciation =
Cost - Estimated residual value

Estimated useful life
Using the example:

Depreciation =
20, 000 - 2, 000

= 1,800
10
[1]
Using the reducing balance method, a constant percentage of the outstanding value is
charged for depreciation each year.
[1]
Page 6
The percentage, r , is determined as follows:

r = 1- n
Estimated residual value

Cost
Using the example:

r = 1 - 10
2, 000
= 20.57%
20, 000
So r is 20.57% and the depreciation charged in the first year will be 4,113.
[2]
[Maximum 8]
Markers: two appropriate numerical examples must be given to award full marks.
Solution X2.13

Equity investors
Equity investors will require information about the companys profitability. They will
want information on its present profitability, the trends in its profitability and the
volatility of the companys profitability in order to assess the expected return from the
share and the risk involved.
[1]
They will also want to know about the companys dividend policy, (ie does the
company tend to reward investors by dividends or by capital gain?) in order to judge
whether or not the companys policy matches their requirements.
[1]
They will also be interested in the proportion of funds obtained from long-term debt
finance. If the company were to be wound up, loan stockholders would receive
payment prior to the shareholders.
[1]
Existing shareholders also require information about the transactions authorised by the
directors for stewardship purposes.
[1]
[Maximum 2]
Loan creditors
Loan creditors will be interested in the companys cashflow and its profitability to judge
how capable the company is of meeting its interest payments.
[1]
Page 7
They will also be concerned with the assets available for sale in the event of the
company being wound up. Debenture holders will be interested in the assets that their
loan is secured against. Unsecured loan stock holders, who will receive payment only
after debenture holders, will be concerned with the total amount of assets compared
with the total amount of loan stock and any prior ranking debt.
[1]
Employees
Employees will be interested in the companys cashflow and its profitability to judge
how capable the company is of paying salaries.
[1]
Employees will also be interested in the continuation of the company and its ability to
offer job security. They will therefore be interested in the long-term profitability of the
company.
[1]
Business customers (eg customers or suppliers)
Business contacts will be interested in the ability of the company to meet future sales
and in the level of future orders for materials and services and will therefore be
interested in the long-term profitability of the company.
[1]
They might use accounting information on gross profit margins to gain some insight
into the companys pricing policies and information on trade receivables and trade
payables to gain some insight into the companys credit policies with its customers and
suppliers.
[1]
[Maximum of 6 from four users]
Markers, please reward other sensible suggestions.
Solution X2.14

(i)
The main purpose of the auditors report and the three aspects of the accounts
The main purpose of the auditors report is to add credibility to the financial statements.
Since the objectives of the various stakeholders in a business often conflict, there is
likely to be a degree of mistrust between them. This mistrust might extend to the
information given by the companys management. The auditors report therefore serves
to reassure shareholders and other stakeholders (though the auditors report is addressed
specifically to the shareholders).
[1]
Page 8
The auditors must exercise professional judgement and comment on whether, in their
opinion:
1.
the financial statements and the part of the Directors Remuneration Report to be
audited have been properly prepared in accordance with the Companies Act
2006 and Article 4 of the IAS Regulation
2.
the financial statements give a true and fair view of the state of the financial
position of the company
3.
the information given in the Directors Report is consistent with the financial
statements.
[2]
[Total 3]
(ii)
The variations to the standard wording of the auditors report
1.
Emphasis of matter paragraphs where a significant uncertainty exists, the

auditor should point this out. It is unnecessary to issue a qualified audit report
because the financial statements give a true and fair view.
[1]
2.
Qualified opinion issued when a restriction has been placed on the evidence
that the auditor can access or where the auditor disagrees with the treatment of a
matter. Effectively the financial statements give a true and fair view except
for the problem that has been described.
[1]
3.
Disclaimer of opinion where the auditor is faced with such extreme uncertainty
about the financial statements that it is impossible to express an opinion. This is
such an extreme form of qualified audit report that it should only be used very
sparingly and in cases where it is unavoidable.
[1]
4.
Adverse opinion in extreme cases of disagreement where the financial

statements have been rendered so misleading that it must be stated that they do
not give a true and fair view. This form of qualified report should be used
sparingly and only when it is absolutely necessary
[1]
[Total 4]
Page 9
Solution X2.15
Comment

This is a past CT2 exam question (from April 2008).
The notes to the accounts provide detailed explanations and additional information to
supplement the financial statements. These details will provide the shareholders with a
better understanding of the position of the company by helping them gain a true and fair
view.
[1]
Many of the disclosures in the notes are required by law or by accounting standards. [1]
Notes might deal with qualitative matters and disclosures that could not be reflected in
the financial statements. For example, descriptions of contingent liabilities could be
vitally important, as could information about post-balance sheet events.
[1]
The notes will also cover details of the accounting policies used in the preparation of the
statements, which will make the accounts more useful to users, eg aiding comparisons
between companies.
[1]
Providing an overview in the main statements and supplementing that with the notes
gives shareholders and other readers the choice of reading further if they wish. Expert
readers can consult the notes while non-experts can stick to the statements themselves.
[1]
Notes and appendices avoid burdening the income statement and balance sheet with
excessive information.
[1]
[Maximum 5]
Page 10
Solution X2.16
Comment

While this question is part of an old past exam question (from the 108 September 2001
paper), it is still relevant and has been updated in line with changes in the Core
Reading, reflecting changes in accounting practice since the time it originally
appeared.
If possible markers will follow through mistakes to see whether or not the correct
principles are being used, and award marks where appropriate.
Income statement for Z plc for the year ending 30 June 2013
000s
Revenue
000s
1,200.00
Cost of sales
Cost of stock used1
449.00
Wages - manufacturing
140.00
Depreciation2
119.66
(708.66)
Gross profit
491.34
Administrative expenses3
(104.00)
Distribution costs4
(230.00)
Operating profit
Interest on loan stock
Net profit before tax
Tax
Profit for the year attributable to equity holders
157.34
[1]
[1]
(120.00)
37.34
(22.00)
15.34
[1]
A dividend of 50,000 was paid to ordinary shareholders during the year in respect of
the year ended 30 June 2012.
[1]
Page 11
Notes
1.
Opening stock + Purchases - Closing stock = 18 + 450 - 19 = 449
2.
Depreciation
3.
[1]
Land and buildings = 2% of 983 = 19.66
[1]
Plant and machinery = 25% of 400 = 100
[1]
Administrative expenses
Administrative overheads = 25
Wages - administrative staff = 44
Directors remuneration = 35
Total = 104
4.
[1]
Distribution costs
Advertising = 200
Wages - distribution staff = 30
[Total for income statement, 8]
Page 12
Statement of financial position for Z plc as at 30 June 2013

ASSETS
Non-current assets
Land and buildings1
Plant & machinery2
Current assets
Inventories
Trade receivables
Total assets
000s
918.34
300.00
1,218.34
19.00
90.00
109.00
1,327.34
[1]
200.00
300.00
145.34
645.34
[1]
EQUITY AND LIABILITIES
Equity
Ordinary share capital
Share premium account
Retained earnings3
Total equity
Non-current liabilities
Loan stock
Current liabilities
Bank overdraft
Trade payables
Tax
Total liabilities
Total equity and liabilities
600.00
6.00
54.00
22.00
82.00
682.00
[1]
1,327.34
[1]
Notes
1.
Land and buildings = 983 - 45 - 19.66 = 918.34
[1]
2.
Plant and machinery = 550 - 150 - 100 = 300
[1]
3.
Retained earnings = 180 50 + 15.34 = 145.34

[1]
[Total for statement of financial position, 7]
[Total 15]
Page 13
Solution X2.17

(i)
Purpose of a cashflow statement
The main purpose of the cashflow statement is to show cash movements over a period of
time. It is needed to supplement the statement of financial position and the income
statement because these two statements do not, on their own, provide sufficient
information about the movement of cash balances.
[1]
The statement of financial position shows the amount of cash at the start and end of
each year, but it does not show the causes of such changes. The cashflow statement
shows the sources and uses of the cash generated by the company during the year,
which is useful when assessing whether a company can continue in its present shape. [1]
The cashflow statement shows the importance of cash:
If a company has too little cash, it could fail. Very few businesses could survive
a prolonged cash outflow. It is often this rather than lack of profits which causes
companies to file for bankruptcy. The cashflow statement will highlight the
source of these problems.
[1]
On the other hand, if the company has too much cash, it is not making the best
use of its resources. The cashflow statement will help the company to consider
the reasons for the cash pile and to assess its options.
[1]
It could invest in other productive assets and earn a better return than it can earn
on cash or it could repay a loan or reward the shareholders (with a large dividend
or an offer to buy back the shares).
[1]
The cashflow statement highlights the differences between profit and cash.
[1]
The income statement registers revenues and expenses before any cash is received or
paid, ie it is constructed using the realisation and accruals concepts. This can give a
very misleading description of a companys financial health. A company can be
profitable but insufficiently liquid.
[1]
The income statement is not affected by some transactions such as acquisitions and
disposals of non-current assets and changes in loan and equity finance. However, these
transactions can have a major effect on the companys cash balances.
[1]
Page 14
The cashflow statement offers an objective statement of the companys cash position.
Both the income statement and the statement of financial position are subjective
statements, which can be manipulated by altering the accounting treatment of particular
items and transactions. The cashflow statement is not subject to such manipulation. [1]
[Maximum 7]
(ii)
Cashflow analysis
Initially, the company does look to be in a healthy cash position, as evidenced by

the fact that the cash balance has increased from 13,000 to 54,000.
[]
Breaking this down into the three constituents, the company has used 59,000 in
its operating activities; it has used 2,450,000 in its investing activities; and has
generated 2,550,000 from its financing activities.
[]
While it seems reasonable to finance investment, it seems less reasonable to

finance operating activities.
[1]
The company has generated 471,000 from operations. During the year, it has
used cash in building up stock (by 44%), increasing its trade receivables (by a
huge 370%!) and decreasing its trade payables (by 66%).
[1]
The company should check that its stock levels are not unreasonably high, that
its credit terms for customers are not unreasonably generous, and that it is
making the best use of available credit from suppliers. It could improve its
cashflow from operations by reducing the cash used in these three areas.
However, it must ensure that there is enough stock to cope with demand, that the
credit terms are sufficiently competitive to generate sales and that it maintains
good relations with suppliers.
[1]
Perhaps stocks were increased in order to cope with greater demand and trade
receivables were increased as a consequence of greater demand (or perhaps to
generate greater demand) arising from the new investment.
[1]
The major outflow of funds from operating activities is the interest paid on the
companys loans. In fact, at the current level of activities it cannot even finance
the current debt interest burden.
[1]
The profit of 800,000 is largely taken up with the 500,000 interest bill. This
low cover of interest is risky because earnings could become negative if profit
were to fall.
[1]
Page 15
The company has preserved some cash by only paying tax due from previous
years. However it has a large outstanding tax liability remaining.
[1]
The company has financed its investment entirely through increased borrowing
(an increase of 52%). The company now has a lot of debt finance relative to
equity finance (ie it is highly geared) which may lead to more expensive
borrowing in the future or force the company to reduce gearing by having a
rights issue.
[1]
Borrowing can be risky because profits might not cover the interest, and also
because if the source of the borrowing dries up, this could lead to the winding up
of the company by the loan stockholders.
[1]
Perhaps the new assets acquired have not as yet been used to full capacity. If
output, sales and profits increase in the following year, then both profit and
cashflow from operations should be better able to cover the interest payments.
[1]
[Maximum 7]

the course.
Page 1
1
10
Solution X3.1
Answer = B
Goodwill is only shown in the consolidated accounts of a holding company with a
subsidiary.
[2]
Solution X3.2
Answer = D
The Stock Exchange provides a market for the buying and selling of shares but does not
actually engage in trading itself. It does not publish commission scales for its member
firms or provide a market for foreign exchange transactions.
[2]
Solution X3.3
Answer = B
Net profit before tax and interest is: 85 + 6 + 10. Therefore interest cover on the ULS
is 101 16.
[2]
Page 2
Solution X3.4
Answer = A
2 or 2 for asset cover (but the exact level will depend upon the quality of assets)
and between 3 and 4 for interest cover (again, depending on the stability of profits)
are normal rules of thumb.
[2]
Solution X3.5
Answer = C
Therefore,
Dividend yield =
dividend per share

share price
Dividend cover =
earnings per share

dividend per share
dividend yield =
earnings per share

1
share price
dividend cover
This expression can then be used to evaluate each of the options.
[2]
Solution X3.6
Answer = C
An associate company is defined as one over which the holding company has significant
influence but not a controlling interest. Wam is therefore not an associate company
it is a subsidiary company.
A significant influence is often taken to mean a holding of between 20% and 50% of the
companys shares. However, a holding company can sometimes hold this proportion of
shares but have little influence. On the other hand the holding company can hold less
than 20% of the shares and yet still have a significant influence.
Both Wizz and Watt are associate companies. Although Techno only holds 18% of the
shares of Watt, it has 1 of the 3 seats on the board and therefore exerts a significant
influence.
[2]
Page 3
Solution X3.7
Answer = C
Intangible assets, eg patents, can be sold, and they do depreciate. Although they maybe
difficult and subjective to value, they do have a value. Goodwill is an intangible asset
that can be created on the consolidated statement of financial position when a holding
company buys a subsidiary.
[2]
Solution X3.8
Answer = D
The return on capital employed has fallen from 32% to 24%. Remember that:
Return on capital employed = Profit margin Asset utilisation ratio
where:
return on capital employed =
profit margin =
asset utilisation ratio =
net profit before tax and interest

long - term debt + equity
net profit before tax and interest

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

30,000
50,000
365 = 55 days in 2011 and
365 = 73 days in 2012 .
200,000
250,000
[2]
Solution X3.11

If Company H is a holding company and has total ownership of its subsidiary
Company S, then Company H will have shares in the subsidiary company as part of its
non-current assets and the shares of Company S will be all owned by the holding
company.
[1]
When preparing consolidated accounts for the group, internal relationships like this are
cancelled out to avoid double counting, and the other items of the balance sheet are
simply added together.
[1]
If Company H paid more than the book value for the shares of Company S, then, when
consolidated, the difference (goodwill) would be recorded as an intangible non-current
asset of the group.
[1]
If Company H does not own all of the shares in Company S, then the rest of the
shareholding is termed the non-controlling interest. On consolidation, when the internal
relationships are cancelled out, the non-controlling interest must appear separately in the
equity section of the statement of financial position, after the capital and reserves
attributable to equity holders.
[1]
If Company A is an associate company of Company H, it is not appropriate to include
the value of Company As assets in the consolidated accounts. Nor is it appropriate to
simply include Company Hs holding of Company As shares as an investment.
[1]
Page 5
Instead, Company Hs share of Company As income and its assets and liabilities are
included as single line entries in the consolidated income statement and statement of
financial position.
[1]
[Maximum 5]
Solution X3.12

(i)
Focus on EBITDA
Earnings before interest and tax (EBIT) is often used to analyse a companys
profitability. For example, it is used to calculate the profit margin and the return on
capital employed. This figure is before tax and interest and is therefore not affected by
the governments tax policy or the companys financing decision.
[1]
However, the figure is affected by the amounts charged for depreciation and
amortisation. These amounts can be determined in many different ways. It is this
subjectivity that makes some analysts feel that it would be better to use the figure for
earnings before interest, taxation, depreciation and amortisation (EBITDA).
[1]
[Total 2]
(ii)
Focus on diluted EPS
The basic EPS ignores the impact of potential future shares, eg shares that might arise
from warrants or convertibles a company has issued.
[1]
If all of these rights are exercised, then the EPS of the existing shareholders will be
diluted, ie it will be less than the basic EPS, as any new equity raised will not
compensate for the number of new shares in existence.
[1]
Analysts may also focus on diluted EPS to avoid distorting other important ratios which
are based on the EPS, in particular the price / earnings ratio which is an important
measure of the markets view of a company.
[1]
[Total 3]
Page 6
Solution X3.13

Goodwill is defined as the amount paid in excess of the nominal value of the shares and
reserves acquired.
[1]
The nominal value of the shares and reserves in Littletom Ltd is 7.5m. Bigtop plc is
going to buy 60% of the companys share capital and reserves. Therefore, the book
value of the asset acquired is 60% of 7.5m, ie 4.5m.
[1]
The share capital of Littletom Ltd is made up of 12 million 25p shares. Bigtop plc will
therefore buy 7.2 million shares.
[1]
It will pay 0.50 (3 1.60) 5.30 for every 5 shares it buys. It will therefore pay:
7.2m
5.30 7.632m
[1]
5
The goodwill is therefore:

7.632m 4.5m 3.132m
[1]
[Total 5]
Solution X3.14

100
= 20
5
216
= 27
Company Ys price earnings ratio =
8
Company Xs price earnings ratio =
[]
[]
The higher price earnings ratio of Company Y is a sign that the market is prepared to
pay a higher price for a given level of current earnings.
[1]
These differences may be due to the two companies being in different sectors of the
market (eg a utility company and a general insurer) where the risks and growth
prospects are different.
[1]
Alternatively there may be some one-off distortion to one of the earnings figures,
eg exceptional items over the past year that are not expected to recur in future.
[1]
Page 7
If the two companies are similar and there are no distortions, possible reasons for this
difference in price earnings ratio are:
The earnings of Company Y are more attractive for some reason. For example
they may be lower risk, more stable, or have a higher level of cover.
[1]
The earnings of Company Y may be more attractive because the growth

prospects for Company Y are better and so its earnings are expected to grow
more rapidly than those of Company X.
[1]
Alternatively, the higher price earnings ratio of Company Y may be an

indication that the share price of Y is too high or that that of Company X is too
low.
[1]
[Maximum 5]
Solution X3.15
Comment

This is a past CT2 exam question (from April 2002).
Basically, the unit price is calculated by the unit trust managers as:
market value of assets
number of units
[1]
The unit trust managers must use this formula but they have some discretion over how
the figure market value of assets is calculated.
[1]
They can calculate it as the cost of buying new assets (ie use the price at which they
would buy the underlying shares and add on stamp duty and stockbroking commission).
This is called offer pricing.
[1]
Alternatively, they can calculate it as the cost of destroying units. This is called bid
pricing.
[1]
The managers can choose to move between offer pricing and bid pricing. Normally,
they will use offer pricing if the unit trust is expanding and bid pricing if the trust is
contracting.
[1]
In order for the unit trust managers to meet expenses and make a profit, an initial charge
(the bid-offer spread) is applied to the unit price.
[1]
Page 8
The way that this is expressed is to define an offer price which is higher than the
bid price. Units are sold to customers at the offer price, but bought back at the lower
bid price.
[1]
[Maximum 5]
Solution X3.16
Comment

This is a past exam question from Subject 108.
The Bank of England provides the liquidity needed by the banking system for
settlement of money market transactions. It allows easy daily settlement of inter-bank
debt eg money that Bank A owes to Bank B.
[1]
The Bank provides liquidity in acting as lender of last resort, otherwise the banks could
run short of money and a financial panic could occur.
[1]
In its money market operations, the Bank of England satisfies the marginal liquidity
demand of the banking system as a whole through open market operations.
[1]
For example, if the market is short of cash, the Bank of England will buy money market
instruments (eg Treasury bills and bills of exchange).
[1]
Similarly, if there has been a large cash inflow into the money markets, institutions can
buy existing money market instruments from the Bank of England.
[1]
The Bank of England also provides cash to the markets through sale and repurchase
(repo) agreements, where an instrument is sold to one party, and a simultaneous
agreement made for the other party to buy it back at a fixed price at a fixed date in the
future.
[1]
[Maximum 5]
Page 9
Solution X3.17

Similarities
The income statements of both insurance companies and other companies

attempt to identify profit, ie the revenue earned less the costs incurred in a
particular accounting year (though this is more complicated in the case of
insurance companies).
[1]
Income includes revenue from the companys normal trading business

(ie insurance or some other) plus income earned from investments and capital
gains made from the sale of those investments.
[1]
The items in the non-technical account of an insurance companys income

statement also occur in a typical company income statement, eg tax is deducted
to find net profit after tax in both types, and current liabilities are similar,
including trade payables and tax provision.
[1]
The general balance sheet equation operates for both insurance companies and
other companies, ie assets equals shareholders fund plus liabilities.
[1]
Equity capital is similar, consisting of share capital and reserves.
[1]
Differences
In the statement of financial position, the types of assets are different. The main
assets of insurance companies are typically investments (including the assets
held to cover the insurance liabilities), whereas for many other companies the
majority of assets are likely to be tangible non-current assets, eg property, plant
and machinery.
[1]
The main liabilities for an insurance company are the future claims that could be
made. In normal company accounts, the main liabilities are usually long-term
debts.
[1]
In normal company accounts, the data for all products sold is amalgamated for
the income statement. For insurance company accounts, separate technical
accounts are prepared for general insurance products and life insurance products.
This is because the different sides of the business may be subject to different tax
rules or different regulatory requirements. It also allows the two distinct
business areas to be assessed separately.
[1]
Page 10
The timing of the reporting of profit is very different for an insurance company
compared with a normal trading company. A company that sells a good in a
particular year is able to estimate quite accurately the cost incurred in making
that sale in that particular year. However, an insurance companys contracts fall
due outside the accounting period.
[1]
The company receives a premium for a policy that might last a number of years.
It might have no claims in the first year but this does not mean that all of the
premium received is classed as profit, because the company must make
provision for future claims from this policy.
[1]
If the company does record this as profit and transfers it to the shareholders the
company may not be able to meet its future liabilities. In practice therefore, the
company sets aside reserves for the policy and the increase in the reserves set
aside in any one year is treated as a cost.
[1]
An additional related problem for insurance companies is new business strain.
strain. Long-term contracts often have high initial acquisition costs, eg
marketing, administration. This, together with the need to set up adequate
reserves for future claims, means that companies often make a loss on a policy in
its early years. In order to reduce this problem, some of these costs are spread
over the future life of the policy.
[1]
The reporting of profit is more complicated for an insurance company because

its future liabilities under a policy are uncertain in size. The company has to
estimate the claim cost on the basis of past history and/or expert judgement. It is
likely to set aside additional amounts to cover any worsening of claim
experience, and to allow for any failure of reinsurers to meet their part of the
liabilities.
[1]
In order to avoid becoming insolvent, the insurance company is likely to be

prudent in its approach to estimating future liabilities. It is likely to overestimate
its future liabilities and therefore current profit is likely to be understated. This
practice conflicts with the realistic approach used by most companies and with
the requirement to provide a true and fair view of the position of the company.
[1]
There is therefore greater subjectivity in the accounts of insurance companies.

The company has to estimate future claims and has to decide how much profit to
record in each time period.
[1]
[Maximum 10]
Page 11
Solution X3.18
Course Reference: Chapters 12 and 13.

(i)
Investment ratios and analysis
Ratio
Earnings per ordinary share (see Note 1)
earnings available for ordinary shareholders
number of ordinary shares

Price earnings ratio
market price
earnings per share
Net dividend yield (see Note 2)

net dividend per share
market price
Dividend cover
=
earnings per share

dividend per share
Return on capital employed (see Note 3)

net profit beforetax
=
share capital and reserves
Return on capital employed (alternative)
net profit beforetax and interest
=
share capital and reserves + long - term debt
Net asset value
ordinary shareholders' equity intangibles
=
number of ordinary shares
Asset gearing (see Note 4)
debt
equity
Asset gearing (alternative)
debt
debt equity
Company A
300, 000
4, 000, 000
= 7.5p
180
7.5
= 24
Company B
200, 000
6, 000, 000
= 3.3p
95
3.3
= 28.8
5
180
= 2.8%
2.5
95
= 2.6%
7.5
5
= 1.5
3.3
2.5
1.32
420, 000
2,500, 000
= 16.8%
495,000
4,000,000
=12.4%
1,500, 000
4, 000, 000
= 37.5p
1,500,000
2,500,000
= 60%
1.5
1.5 2.5
320, 000
3, 000, 000
= 10.7%
350,000
3,500,000
=10%
2,500,000
6,000,000
= 41.7p
500,000
3,000,000
= 16.7%
0.5
2.5 1
= 37.5%
= 14.3%
Page 12
Notes
1.
The earnings for ordinary shareholders of Company A has been calculated as

360,000 less the amount payable to preference shareholders of 60,000.
2.
The net dividend per share for Company A has been calculated as:
net dividend
200,000
5p
number of shares 4,000,000
3.
We have included the return on preference shares in this definition. It would

have been acceptable to define a ratio only for the ordinary shares of:
=
4.
net profit before tax preference payment

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

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

unusually low
Company A is undervalued or Company B is overvalued.
[2]
Company A has a slightly higher dividend yield, ie the income return is a higher
proportion of the market price of the share. This supports the view that Company A
looks slightly cheaper. Company A is achieving a higher dividend yield on a lower
payout ratio, ie Company A is not achieving a higher dividend yield by simply paying a
higher proportion of its earnings as dividend.
[1]
Page 13
Company A has a higher dividend cover (and thus a lower payout ratio) than
Company B. Thus Company A is retaining more of its profits within the company and
distributing less to its shareholders than Company B. This might indicate higher future
earnings growth.
[1]
Company A has a higher return on capital than Company B. Company A is using its
assets more effectively to generate profits.
[1]
Company A has a lower net asset value per ordinary share (NAV) than Company B.
This is particularly noticeable if we look at the ratio of net asset value and market price
per share. Thus if the company were wound up (at the present time), a shareholder in
Company B may receive more than a shareholder in Company A. This might also mean
Company B might be a takeover candidate (although unlikely whilst NAV remains
below the market price).
[1]
Company A has a higher gearing ratio than Company B (and considerably above the
debt
recommended maximum of 0.4 using the =
basis). The additional funds
debt equity
made available by debt finance would give Company A greater potential for growth but
the higher gearing also makes it more vulnerable to the downturn in the business cycle
and reduces the funds available to shareholders if the company were to be wound up.
[1]
Conclusion
Thus Company A is a highly geared company that gives greater priority to growth and
earns a higher return on capital. It has a lower payout ratio yet has a higher dividend
yield this is in addition to the prospect of a greater capital gain. Company B appears
to be a slower growing company, which takes fewer risks but offers stability and better
asset backing.
[1]
Company A might be chosen if the investor seeks growth and can handle the risk.
Company A also looks cheaper (probably because of the high risk), whereas Company
B might be preferable for an investor requiring security.
[1]
[Maximum 6 for comments]
[Total 12]
Page 14
(ii)
Problems in making comparisons
There is a great deal of subjectivity in the accounts. The two companies might have
used very different accounting policies on, for example, depreciation or the treatment of
intangibles, so the accounting data is not strictly comparable. Even though the
companies might follow accounting standards, the interpretation can be different and so
any comparison will be tenuous.
[1]
The different methods of treating an item in the accounts can be very important,
depending on the nature of the business. For example, intangibles may be significant
for an advertising company, and therefore the policy chosen will dramatically affect its
profitability.
[1]
The use of ratios to make comparisons can divert attention from the wider view of the
company. In this case, we have very little information to go on and should not place too
much emphasis on the ratio analysis.
[1]
Companies operating in different sectors would be expected to have different capital
structures and different accounting ratios. For example, an advertising agency is likely
to be more lowly geared than a car manufacturer.
[1]
Companies in different sectors are exposed to different conditions. For example, a car
manufacturer is likely to be more exposed to recession at home and abroad than a food
manufacturer.
[1]
The figures reported in the accounts are out of date by the time they are published. In
addition, some of the data might suffer from window-dressing, for example, a sale
might have been brought forward in order to enhance the profit figure for the year. One
or both of the firms might have engaged in creative accounting, ie the deliberate use of
particular accounting policies in order to show particular results.
[1]
Care must be taken in using the figures as a basis for predictions since the accounts do
not give any indication of the companys future plans. A full reading of the annual
report might give the user some indication.
[1]
[Maximum 4]
(iii)
Page 15
Additional information required
The following information will be useful:
Other accounting information. For example, information on sales revenue

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

What is the quality of
management/staff/product in each company? Have there been any changes in
the management/ style/ priorities? How has each company performed over
time? To what extent is the information given typical of each company?
[1]
Prospects for the two companies. What are their business plans? Which
company could achieve better results in the commercial, economic, political and
technological climate ahead?
[1]
Preference of the investor. Does your friend, the investor, want a regular
dividend or a capital gain? What is his/her attitude to risk?
[1]
[Maximum 4]
Markers, reward reasonable suggestions.
Page 16
Solution X3.19
Course Reference: Chapter 12 for part (i) and Chapter 13 for part (ii).
(i)
XYZs liquidity, efficiency and profitability
Liquidity
quick ratio
= (cash + trade receivables) current liabilities

= (1,552 + 600) (2,512)
= 0.86
[1]
current ratio = current assets current liabilities

= 3,552 2,512
= 1.41
[1]
The quick ratio is a stringent liquidity ratio. A ratio of 1 means that the companys
trade receivables and cash are sufficient to cover its short-term liabilities. A figure of
0.86 is just about acceptable, meaning the company can probably meet its liabilities as
they fall due.
[1]
The current ratio is a less stringent test of liquidity. A figure of more than 1 would be
expected, and preferably greater than 1.5 (although this varies between industries). A
figure of 1.41 suggests that the company has sufficient liquid assets to cover its shortterm liabilities.
[1]
It would be useful to look at trends over time in both of these ratios, and to compare
them with other companies in the same industry.
[1]
Efficiency
stock turnover period
= (inventories cost of sales) 365

= (1,400 1,700) 365
= 300 days
debtors turnover period
[1]
= (trade receivables credit sales ) 365

= (600 ( 4,000 ) ) 365
= 109 days
`[1]
creditors turnover period
Page 17
= (trade payables purchases) 365

= 1,800 1,300 365
= 505 days
[1]
A few variations are possible. The stock turnover period could have been calculated as:
= (inventories sales revenue) 365
= (1,400 4,000) 365
= 128 days
The stock turnover period shows how long inventories are held for on average. The
figure of 300 days in terms of sales (or 128 days in terms of revenue) can only be
interpreted if we know what the figure is for similar companies. However, this figure
seems quite high, and may suggest inefficiency.
[1]
The debtors turnover period is most useful as a tool to compare the performance from
one year to the next. On its own it shows the number of days credit extended to the
average debtor. 109 days is quite high the company should consider reducing the
amount of credit extended to customers or chasing up later payers.
[1]
The creditors turnover period shows the number of days credit it receives from its
suppliers. 505 days seems very high. This will help the companys cashflow and, in
particular, helps cover the credit given to its customers, but such late payment of bills
might annoy suppliers.
[1]
Profitability
return on capital employed
= net profit before tax and interest (debt+equity)

= 1,600 4,040
= 39.6%
net profit margin
[1]
= net profit before tax and interest sales revenue

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

= 4,000 4,040
= 0.99
[1]
Page 18
The return on capital employed shows how productive the capital has been in
generating profits. 39.6% is a high figure and shows that a very good return is being
earned on the assets under management.
[1]
The net profit margin indicates the mark-up achieved on sales. The company will aim
for a high mark-up but has to consider the effect of a high mark-up on the volume of
sales.
[1]
40% seems quite high for a manufacturing company and may indicate:
an efficient company
a company selling up-market products
supernormal profits.
[1]
The asset utilisation ratio shows the sales that are generated from the companys assets.
The ratio of 0.99 is relatively low, though it depends on the nature of the business. [1]
The companys sales could be suffering from its high profit margin. Perhaps the
company is using its assets inefficiently. Better management might allow it to produce
just as much output with fewer assets.
[1]
[Maximum 16, with a maximum of 7 for calculations]
(ii)
Using optimistic accounting policies to increase the share price
The practice is unlikely to increase the share price. Companies are obliged to publish
their accounting policies in the notes to their accounts and so much of any optimism
in accounting policies will be visible to the market.
[1]
Shareholders, analysts and other market participants who inspect the accounts will
notice if any policies are unduly optimistic, particularly if the policies have changed to
become more optimistic since previous years.
[1]
The analysts will discount the over-optimistic values in the accounts and reflect this in
their valuation of the company.
[1]
The accounting policies will have to be agreed by the auditors who may highlight any
undue optimism in their audit report, perhaps by issuing a qualified opinion.
[1]
Indeed, it is possible that XYZs share price will fall as the market may lose confidence
in the companys accounts and may be more suspicious in future.
[1]
[Maximum 4]
Page 1
1
10
Solution X4.1
Answer = C
The return on the share would be described by the following formula:
ri r f i (rm r f )
5% 1.5 3% 5%
2%
[2]
Solution X4.2
Answer = C
In a tax-free world, the following formula links the returns:
return on assets =
D
E
(return on debt) +
(return on equity)
D+E
D+E
12% = (0.25 6%) + (0.75 return on equity )
Thus: return on equity = 14%
Page 2
Alternatively, we could calculate the return on equity directly as r f + b g (rm - r f ) .

We know that rm = 12% , r f = 6% . We also know that the assets of the company are
invested to give a market return. Therefore, we can say that the beta of the assets must
be 1 and b u , the ungeared beta, is also 1, since the beta of the assets is always the same
as the ungeared equity beta. So, if the company had no debt, the beta of the shares
would be 1. However, since there is debt, we adjust the beta according to the following
formula:
b g = b u 1 +
D
25
(1 - t ) = 1 1 + (1 - 0) = 1.333
E
75
So, the return on the geared shares is:

r f + b g (rm - r f ) = 6% + 1.333 (12% - 6%) = 14%
[2]
Solution X4.3
Answer = D
Modigliani and Millers first irrelevance proposition states that the market value of any
firm is independent of its capital structure so all of answers A to C are incorrect.
[2]
Solution X4.4
Answer = C
The weighted average cost of capital (WACC) is found as follows:
WACC =
D net cost of debt + E cost of equity

D+E
We can find the net cost of debt as follows:

Net cost of debt = (1 - t ) gross cost of debt
= 0.7 7% = 4.9%
Page 3
The cost of equity can be found as follows:

Cost of equity = risk - free rate of return + b r equity risk premium
where b r is the beta of Rapidos equity shares.

We can find beta as:
br =
cov( r, m) 0.06
=
= 1.5
var( m)
0.04
So:
Cost of equity = 3% + 1.5 8%
= 15%
The WACC is therefore:

0.4 4.9% + 0.6 15% = 10.96%
[2]
Solution X4.5
Answer = A
All of B, C and D would lead to debt being more attractive and so tend to suggest a
higher level of gearing.
[2]
Solution X4.6
Answer = D
[2]
Systematic risk arises because of the volatility of the market as a whole.
Solution X4.7
Answer = C
Only the effects of regional price variation can be diversified away by investing in a
large portfolio of risky assets and projects.
[2]
Page 4
Solution X4.8
Answer = C
The following diagram compares the net present value of the projects as the discount
rate varies.
NPV
100
50
Project B
5
-50
10
15
Discount rate
Project A
Project A is more profitable than Project B at a discount rate of 5%, but not at all
discount rates.
The internal rate of return is the discount rate at which the net present value is zero.
The internal rate of return for Project A is 10% and the internal rate of return of Project
B is at least 15%.
The net present value of Project A at a discount rate of 15% is negative. Thus it will not
earn a 15% return.
Project B is less sensitive to a change in the discount rate as the diagram shows.
[2]
Solution X4.9
Answer = B
An increase in gearing increases the risk of default and thus the companys credit rating
will fall. It will have to pay more for its debt finance.
[2]
Page 5
Solution X4.10
Answer = C
Systematic risk is allowed for by using an appropriate discount rate. Specific risk is
allowed for in the other ways.
[2]
Solution X4.11

In order to reduce the volatility of profits, the management could do any of the
following:
Reduce the gearing of the company by issuing more equity shares.
Negotiate contracts with suppliers which involve the suppliers taking some of
the risks, and consequently some of the volatility of profits.
[1]
Take out insurance against certain risks.
Organise export guarantees to protect against the default of trading partners in

foreign countries.
[1]
Use currency hedging techniques to reduce the effect of currency volatility on

translated profits. This could involve options on currencies, or selling an
appropriate amount of the foreign currency forward to hedge the value of the
profits in the domestic currency.
[1]
Organise its debt so that payments of interest and repayments of capital are in
the same currencies as its earnings, eg by using Eurobonds.
[1]
[Maximum 4]
[1]
[]
Page 6
Solution X4.12

(i)
Methods of conducting the share buyback operation
The company could:
inform the shareholders of its wish to repurchase a fixed number of shares at a

fixed price (usually above the current market price) and invite shareholders to
offer their shares to the company.
[1]
inform the shareholders of its wish to repurchase a number of shares by auction.

In a uniform price auction, the company asks each shareholder how many shares
they would be willing to sell and at what price, whereas in a Dutch auction, the
company asks each shareholder how many shares they would be willing to sell at
a series of set prices. From this information, the company calculates the lowest
price at which it can buy the required number of shares.
[1]
inform the shareholders of its wish to repurchase a number of shares and do so

gradually in the open market.
[1]
inform the shareholders of its wish to repurchase a number of shares and to do so

by direct negotiation with a number of major shareholders.
[1]
The company could find it difficult to find sellers. Reluctance to sell will bid up the
price.
[1]
[Maximum 4]
(ii)
Advantages and disadvantages to the shareholders
Advantages to the shareholders
The expected rate of return to the shareholders will increase because there will
be a higher proportion of cheaper and more tax-efficient debt finance.
[1]
Debt interest payments are deducted from profits before the calculation of the
tax charge. This reduces the tax charge. If debt interest is compared to equity
income, it can be seen that the government is effectively paying the amount of
the tax charge to the investor on behalf of the company.
[1]
The tax treatment of capital gains may be more favourable than that of
dividends, eg if an individual investors capital gains allowance has not been
used up.
[1]
Page 7
Disadvantages to the shareholder
The increased gearing increases the risk to the shareholder, eg of a fall in

operating profit, a fall in asset values, the company being wound up.
[1]
This increases the volatility of reported earnings for the equity shareholders. []
In addition there will be a higher risk of default on interest and on capital for the
outstanding debt, so it should not be assumed that the new debt can be issued on
similar terms to the existing debt.
[1]
Potential creditors will bear in mind that Z plc, as a media company, has few
tangible assets and may be vulnerable to a downturn in the business cycle.
[1]
If the companys credit rating falls, it may affect almost all of the companys
long-term and short-term borrowings.
[1]
The knock-on effect of any increased risk and volatility of earnings would be to
cause the equity shareholders to demand a higher return for holding the shares.
[1]
Shareholders like to make their own buying and selling decisions and may feel
that they are being forced (or strongly encouraged) to sell when they do not
really want to.
[1]
Some investors may not gain any tax benefit, eg investors who have no capital
gains allowance or individuals who have used up their allowance.
[]
There will be fewer shares, so they may become less marketable.
(iii)
Effects on the share price
[]
[Maximum 8]
The share price will rise in the short term as a result of the increased demand for the
share.
[1]
In the longer term, the share price depends on the markets reaction to the share
buyback.
[]
The market might react positively if the increased gearing is thought appropriate for the
company. Given that the company is established and possibly therefore has limited
growth possibilities (so that there is little possibility of the company being short of
funds in the future), the market may welcome this opportunity to make better use of
shareholders funds.
[1]
Page 8
The market might react badly if the new capital structure is thought to be inappropriate
for the company. As a media company, Z plc is probably quite susceptible to the
business cycle, so the increased gearing could cause significant increases in volatility of
earnings (though, as an established successful company it possibly has strong brand
loyalty to withstand competition in difficult trading conditions).
[1]
The share price will increase if the equity holders appreciate the enhanced prospects for
the growth of earnings per share (EPS) and are not concerned by the additional
volatility of earnings. However, the share price will not change if shareholders feel that
the increased EPS prospects are only just sufficient to compensate them for the increase
in volatility.
[1]
If the shareholders are more concerned about the additional volatility and risk of default
than the possible increase in EPS, the required return to hold the shares will have to rise
sufficiently so as to more than offset the increased earnings prospects, ie the share price
will fall.
[1]
[Maximum 4]
Solution X4.13

Proposition 1: The market value of any firm is independent of its capital structure, ie a
firms value is determined by its investment decisions, not by its financing decisions. [1]
An increase in a companys gearing will increase the expected return to equity but this
is not achieving anything the shareholders could not do themselves. Thus, the market
value of the company is unchanged.
[1]
This assumes that shareholders can borrow at the same rate as companies, and that there
is a perfect capital market and no tax.
[1]
Proposition 2: The expected return on equity increases with the debt/equity ratio
expressed in market values.
[1]
If a company with no debt finance issues debt and repurchases its own shares, then its
expected rate of return increases. Interest payments are fixed and, with a low earnings
figure, earnings per share would be higher in the ungeared situation. However, given
the lower number of shares, the higher the earnings, the greater the earnings per share in
the geared situation compared with the ungeared situation. Thus, the expected return to
equity increases.
[1]
Page 9
However, the increased debt carries an increased risk. The greater the debt, the less
likely that the assets could be sold to pay off the creditors in full if the company were to
be wound up. Also, the greater the debt, the greater the interest payments that have to
be made, and thus the greater the risk of the equity holders receiving a low dividend in
difficult times. This increased risk increases the reward required by shareholders.
[1]
As gearing increases, the risk to the creditors increases too and thus the cost of debt is
likely to rise. If the debt cost rises with increased gearing, the return to equity tails off.
[1]
[Maximum 5]
Solution X4.14

(i)
Additional information required
Background information explaining the reasons for the companys hard times.
Is it a temporary problem caused by particular business or market conditions, or
is it a long-term structural problem with the company, perhaps reflecting a longterm alteration to business conditions and customer habits?
What is the restructuring package, over what timeframe is it likely to cure the
problems and what is its likelihood of success?
What is the companys cash situation? Can it continue to finance a dividend

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

disappointed in the companys payout over the next two or so years?
Page 10
Following the restructuring, by how much is the companys level of profitability

likely to rise? Is it the case that the profitability and earnings creation is likely to
return to former levels, or were former levels higher than can ever be expected in
the future?
[1 mark for each relevant well-argued point, maximum 5]
(ii)
Strategies that could be considered
No dividend over the period of the restructuring. This might be appropriate if

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

structure and size of the typical projects undertaken. This can cause
business area to grow at the expense of another and can cause political
internal frictions.
the
one
and
[1]
Page 11
The policy may encourage managers to split large projects artificially into many
smaller projects.
[1]
The high rate of return demanded for larger projects will encourage high-risk
projects. Perhaps this is the managements aim, but it should not be by accident.
[1]
The low rate of return for smaller projects might allow the company to spend a
great deal of money on unprofitable projects unless it has other methods to limit
its finite resources.
[1]
[Maximum 3]
Solution X4.16
Course Reference: Chapter 17 for part (i) and Chapter 18 for part (ii).
(i)(a) Annual capital charge
This is very similar to the accounting depreciation charge calculated on a straight line
basis. The table below gives the net cashflows after the annual capital charge:
Time in years
Cashflow in $ millions
Initial investment
charge
Annual capital charge
(6)
1
(2)
4
(2)
3
(2)
(1)
This shows the effect on the income statement of the investment after depreciation. It is
appropriate for investments such as this that involve the purchase of machinery. The
machinery is likely to be depreciated over a three-year period, and the annual capital
charge method shows directly the effect on the reported profitability.
[1]
(i)(b) Payback period
This is defined as the point in time at which the positive cashflows equal the negative
flows over the life of the project. For the above project this will be at the end of year 3.
[1]
Page 12
(i)(c) Nominal return over 3 years

Nominal return is calculated as the ratio of the amount of positive cashflows to the
negative cashflows over the specified period.
For this project it equals 8/6 = 1.33
The fact that this is greater than 1 is a positive sign for the project. However the method
ignores the time value of money.
[1]
[Total 3]
(ii)
Probability trees
Probability trees are of use in situations where decisions have to made at various points
in time as a project is progressed. Each of these decisions may constrain the project
manager in terms of the option he or she may take in future.
[1]
They are of particular use when the probabilities of certain events can be refined and
clarified with the passage of time. Decisions can be made in the future with the benefit
of knowledge of prevailing market conditions.
[1]
A tree of decisions can be drawn up reflecting all the possible future scenarios, and the
various decisions that have to be made in the future. The likelihood and probabilities of
future events, and the resulting cashflows can be estimated and assigned to each
scenario.
[1]
It is then possible to work backwards to establish the most beneficial decision at the
current time, and the likely value of the project.
[1]
[Maximum 3]
Page 13
Solution X4.17

(i)(a) Meaning of specific and systematic risks
Specific risks are the risks that are specific to that particular project. If an investor were
to build up a portfolio of such projects, these risks would be diversified away and the
overall portfolio of projects would not be exposed to any specific risks from any one
project.
[1]
Systematic risks are the risks that cannot be diversified away. They are the risks of
being exposed to the market in general. Some industries are simply more geared to the
performance of the economy in general (so-called cyclical industries) and therefore
are exposed to more systematic risk.
[1]
(i)(b) Meaning of beta
The beta of a project is a measure of the systematic risk of the project relative to a
diversified portfolio of all risky assets (ie the market). The market would have a beta
of 1.
[1]
( )
The beta of the project b p is given by the following formula:
pm
m2
where:
pm is the covariance between the returns expected from the project and the
returns expected from the market
m2 is the variance of the returns expected from the market
[1]
[Total 4]
(ii)(a) Required rate of return on project

The required return on a project is found from the following formula:
rp rf p rm rf
Page 14
In this case, the required return is:
= 4% + 0.6(6%)
[2]
= 7.6%
(ii)(b) Explanation for low rate of return on a risky project
The beta of the project measures the systematic risk only, ie the extent to which the
project is exposed to market risk. In this case, this risk is relatively low.
[1]
The specific risk is not measured by the beta of the project. In this case, this risk seems
very high. The company will have to take other steps to assess the specific risk,
eg RAMP, risk matrix, scenario testing.
[1]
[Total 4]
Solution X4.18
A risk matrix is a matrix that shows the different causes of risk as column headings and
the list of all specific risks that might befall the project at the different stages of the
project as row headings (or vice versa if matrix is transposed).
[1]
The causes of risk can be classified under many subheadings, but there will often be
seven main classes of risk, namely:
Political
Natural
Crime
Financial
Business
Economic
Project.
[Maximum 3, deduction for each missing category]
Within each of these categories there may be many sub-categories. For example,
economic risk causes might be further classified into currency fluctuation, short interest
[1]
rate movements, etc.
Page 15
Typically, the risks might be labelled in the following main categories:
promotion of concept
design
contract negotiations
project approval
raising of capital
construction
operation and maintenance
receiving revenues
decommissioning.
[ mark for each up to a maximum of 3]
Again, within each of these categories there might be many sub-categories. For
example, within the heading construction there may be a number of specific risks
listed such as higher raw material costs, difficult excavation.
[1]
Uses of the risk matrix
The matrix allows the risk analyst to ensure that he or she has systematically and
comprehensively considered every risk that might affect the project and that nothing has
been overlooked.
[1]
It also allows the analyst or risk manager to keep track of the risks in chronological
order as the project proceeds, and allows the project manager to make sure he or she is
considering all the relevant risks at each stage in the project.
[1]
It allows the analyst to identify correlations between risks many of the specific risks
listed may be highly correlated to a specific cause of risk. This may mean that these
risks need further detailed analysis because of their interdependency and potentially
larger combined impact.
[1]
[Maximum 10]
Page 16
Solution X4.19
(i)
WACC
The market capitalisation of the loan stock or the equity shares is the value of all the
issued bonds or equity share, valuing each at its market price. It would be defined as:
number of shares (or bonds) issued market price per share (or bond)
[1]
The weighted average cost of capital (WACC) is:

=
Debt net cost of debt + Equity cost of equity

Debt + Equity
[]
The required return on the debt is the average GRY, ie 10%

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

=
200m 7% 800m 18%

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

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

If the project is similar to the projects usually undertaken by the company, then the
company beta can be used as a surrogate for the project beta. Hence the project can be
assessed at the companys usual weighted average cost of capital.
[1]
Page 17
If the company invests in a wide variety of projects through its different divisions,
perhaps it has already estimated the project betas for each division, and thus an
appropriate beta can be found for a particular project.
[1]
Difficulties arise if the project is very different from the projects usually undertaken.
There are two main options in these circumstances.
It might be possible to find a company which invests only in this sort of project. The
beta of the equity shares of that company would give a starting point from which to
estimate the beta of the project. The beta of the shares could be measured by
monitoring the return on the shares over 52 weeks (say) and monitoring the return on
the market over the same 52 periods. Then it would be possible to calculate the
covariance and the variances required to apply the following formula:
bi =
Covariance between stock i's return and the market return

Variance of the market return
[1]
Following this step, it would be necessary to adjust the measured beta for the effect of
gearing.
[]
If the company cannot find a company beta to use as a proxy for its project beta, it could
estimate the project beta by creating a stochastic model of the project. Using this model
it could estimate the correlation between the prospective project returns and the market
returns and the standard deviation of the project and market returns. Hence, the project
beta could be calculated using the formula shown above.
[1]
Alternatively, using the projections from the model, the company could plot the
projected returns to the project against the risk premium in the market as a whole on a
scatter diagram, find the line of best fit and then use the following formula:
rp r f p rm r f
to find b p as the gradient.
[1]
[Maximum 4]
(iii)
Relationship between WACC and 14%
If the WACC is used as a hurdle rate of return, then the project would probably not take
place. The projects internal rate of return has been estimated at 14% and the hurdle
rate is 15.8%. The project return is clearly beneath the WACC and as such would not
seem to be appealing. If the WACC were used as the discount rate, the project would
have a negative NPV.
[1]
Page 18
However, we must ask whether or not the WACC is an appropriate hurdle rate for this
particular project. The project should be appraised using the rate of return appropriate
to the systematic risk of the project, not the WACC (which will equate to the average
systematic risk of all the companys projects).
[1]
For example, if the beta of the project were estimated to be 0.5, then the project would
be required to make a return:
= risk-free return + p equity risk premium
= 6% + 0.5 (8%) = 10%
Using 10% as the hurdle rate, this project would certainly be worthwhile.
[1]
If we assume that the internal rate of return estimated for the project fully reflects the
risks involved, the beta would be estimated from the following:
14% = risk-free return + p equity risk premium
14% = 6% + p 8%
Therefore p = 1. The project has a normal level of systematic risk and less than the
companys assets as a whole.
(iv)
[1]
[Total 4]
Worthwhile or not
It is true that the cost of borrowing would be below the return earned on the project.
However by borrowing debt, the company would be increasing the systematic risk of
the remaining equity capital.
[1]
This can be demonstrated by the following formula:
geared beta = ungeared beta (1
debt
(1 t ) )
equity
[1]
(This formula assumes that debt is risk-free, but it provides an approximate relationship
where this is not the case.)
The greater the gearing, the higher the beta of the equity shares.
[1]
Page 19
Therefore, although the borrowing is cheaper for this particular project, the cost of
capital (WACC) for the whole company might increase overall. This would make all
the existing projects less profitable and the result may be negative overall for the
company.
[1]
[Total 4]
(v)
Which WACC?
It is true that new capital will alter the existing cost of capital. However this should not
prevent WACC being used.
[1]
How to proceed
It may be possible to calculate the optimum cost of capital using the best possible
split between debt and equity. This should be the case regardless of exactly how the
project in question is to be financed.
[1]
Projects could be assessed against this rate, and any departure from this capital structure
would be treated as a loss due to inefficient management of capital rather than altering
the expected profitability of any project.
[1]
In other words, the decision to finance the project in a manner that is inconsistent with
the companys minimum WACC is independent of the choice of WACC used to
discount the cashflows from the project and should not therefore influence that choice.
[1]
Alternatively, and this solution would be preferred by modernists, each project should
be assessed using the ungeared cost of equity. The value of the tax shield would then be
apportioned between the various projects that the company is undertaking in some
appropriate manner.
[1]
By tax shield we mean the tax saved by having loan capital in the company. This
would be calculated as:
Loan capital gross cost of debt corporation tax rate
and would be shared out between the projects in a manner to be determined by

management.
[1]
[Maximum 4]

the course.

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Information asymmetries often exist between various classes of stakeholder (managers,

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The administration of debt collection would be undertaken by the factor. This

Advantages of recourse factoring for Country Dairy Ltd:

Recourse factoring would be cheaper than non-recourse factoring. If Country

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The hedges mitigate the currency risk because:

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Theoretical ex-rights share price

Number of issued shares before the rights issue:

Rights issue price = (1 20%) 3.75 = 3.00

Theoretical ex-rights share price:

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Course Reference: Chapter 6.

Reasons for seeking a listing

Disadvantages of obtaining a listing (for existing shareholders)

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These disadvantages are particularly relevant if the company is current owned by a

Relative attraction of various issuing methods

Offer for sale (at a fixed price)

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Offer for subscription

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