ct2 2010-2013

Faculty of Actuaries Institute of Actuaries
EXAMINATION
29 April 2010 (am)
Subject CT2 — Finance and Financial Reporting

Core Technical
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3. Mark allocations are shown in brackets.
4. Attempt all 20 questions. From question 11 onwards begin your answer to each
question on a separate sheet.
5. Candidates should show calculations where this is appropriate.
Graph paper is NOT required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
© Faculty of Actuaries
CT2 A2010 © Institute of Actuaries
For questions 1–10 indicate in your answer book which one of the answers A, B, C or D is
correct.
1 Which of the following statements best describes the duties of a company’s board of
directors?
A The directors should maximise shareholder wealth and ignore externalities.
B The directors should maximise shareholder wealth and respect regulatory

constraints on the imposition of externalities.
C The directors should maximise shareholder wealth and seek the greatest
possible social benefit.
D The directors should maximise social welfare.

[2]
2 Which of the following statements best describes why sellers are prepared to offer
their customers trade credit?
A Business customers are unlikely to buy on cash terms.

B Credit sales provide a steady inflow of cash.
C It costs nothing to provide the customer with trade credit.
D Selling on credit simplifies the administration of the sales process.
[2]
3 In which of the following circumstances would it be inappropriate for a company to

enter into an interest rate swap?
A The company has a comparative advantage in borrowing at a fixed rate of

interest.
B The company has a comparative advantage in borrowing at a floating rate of

interest.
C The company has a floating rate loan and wishes to protect itself against
interest rate rises.
D The company wishes to create greater flexibility in the eventual settlement of

its liabilities.
[2]
CT2 A2010—2
4 A company has consistently made losses for tax purposes for several years and it does
not expect to make taxable profits for several years further. Which of the following
statements best justifies borrowing rather than issuing further shares in order to raise
funds for expansion and recovery?
A Existing shareholders have nothing to lose.

B Interest is an expense for tax purposes.
C Lenders cannot be affected by a company’s failure.
D Potential shareholders are likely to be deterred by the ongoing losses.
[2]
5 A company has a substantial cash balance for which it has no immediate use. Which
of the following would NOT be a valid reason for it to release this cash to
shareholders by means of a repurchase rather than a dividend?
A potential tax advantages to the company

B potential tax advantages to the shareholders
C provision of an exit opportunity for a provider of startup equity
D the repurchase can be scheduled for any time of year
[2]
6 Historically, which of the following best explains why investments in equities have
tended to outperform fixed interest investments in the very long term?
A Equity investors accept greater risks.

B Equity investors tend to overstate the returns from their investments.
C The returns on each type of investment are calculated in different ways.
D Returns from fixed interest investments ignore the effects of inflation.
[2]
7 Which of the following is responsible for ensuring that the financial statements
published by a company give a true and fair view?
A the board of directors

B the chief accountant
C the external auditor
D the finance director
[2]
CT2 A2010—3 PLEASE TURN OVER

8 S is a holding company that has two subsidiaries, T and U. During the year, S made
sales of £1.0m, including sales of £0.2m to T. T made sales of £2.0m, including sales
of £0.3m to U. U made sales of £4.0m including sales of £0.6m to S.
Which of the following is the correct figure for group sales according to the
consolidated income statement that will be prepared by S?
A £0.8m
B £1.0m
C £5.9m
D £7.0m
[2]
9 Which of the following would artificially understate stock (or inventory) turnover,
expressed in days?
A Delay the replacement of inventory that would normally occur before the year
end until just after.
B Introduce a new marketing strategy that increases sales during the year.
C Advance the replacement of inventory that would normally occur just after the
year end until just before.
D Purchase goods for cash instead of on credit.

[2]
10 A company purchased an inventory item for £10.00 and sold it for £12.00. Due to
rising prices, the inventory item cost £12.40 to replace.
Which of the following statements best describes the effects of the sale and
replacement of this inventory item?
A The company will recognise a profit of £2.00 under historical cost accounting,
but has made a real loss of £0.40.
B The company will recognise a profit of £2.00 under historical cost accounting,
and it has made a real profit of £2.00.
C The company will recognise a profit of £0.40 under historical cost accounting,
D The company will recognise a profit of £0.40 under historical cost accounting,
[2]
CT2 A2010—4
11 Information asymmetry has been identified as a serious problem for shareholders.
(a) Explain what is meant by “information asymmetry” in the context of limited

companies.
(b) Explain the role of financial reporting as a means of resolving information

asymmetry for shareholders.
[5]
12 An individual investor is considering making an investment in an investment trust, but

is deterred by the fact that many investment trusts trade at a discount to their
underlying net assets.
(a) Explain why the discount exists.
(b) Explain why investment trusts may still be a sound investment for an
individual shareholder.
[5]
13 An unquoted company wishes to raise a large loan in order to invest in a major new
project. The finance director has proposed issuing bonds that have a significant
number of warrants attached.
Describe the advantages and disadvantages to the company’s existing shareholders of

attaching warrants to the bond issue. [5]
14 Describe the advantages of raising additional equity finance by means of a rights

issue. [5]
15 A small company engaged a firm of consultants to evaluate a very complicated

investment opportunity. The consultancy devised a Monte Carlo simulation and ran a
very large number of iterations. They discovered that the project generated a positive
net present value for 85% of the simulations. The directors of the company believe
that this result is sufficient for them to justify investing in the project.
Explain how the directors should go about interpreting the results of this simulation
before making a final decision on the project. [5]
16 Describe the purpose of a cash flow statement. [5]

17 A company has entered into an unusual transaction that is not covered by any specific
accounting standard. As a consequence, the directors are unsure how to account for
this in the annual report and are tempted to choose the treatment that gives the highest
reported profit.
Explain how the directors should go about selecting an appropriate accounting policy
for this transaction. [5]
18 The directors of a limited company receive an annual bonus that is linked to reported
profit. Explain how unscrupulous directors could go about overstating the reported
profit without risking the legal and other penalties that would be imposed if they
falsified the financial statements. [5]
19 The following information was extracted from the draft financial statements of
Gander plc:
Draft balance sheet as at 31 March 2010

ASSETS
Non-current assets
£m
Property, plant & equipment 200
Current assets 21
Total assets 221
EQUITY AND LIABILITIES

Share capital 100
Other reserves –
Retained earnings 61
Total equity 161
Non-current liabilities
Long-term borrowings 50
Current liabilities 10
Total liabilities 60
Total equity and liabilities 221
Property, plant and equipment includes land and buildings that have a book value of
£150 million. The directors commissioned an independent valuation of the land and
buildings and have been advised that they were worth £240 million on 31 March
2010.
CT2 A2010—6
Gander plc’s long-term borrowings have a covenant in place that requires that the
directors must seek permission from the lender before taking out any further loans
that would have the effect of increasing gearing (measured as long term liabilities as a
percentage of equity plus long term liabilities) to more than 25%. The directors wish
to borrow a further £30 million and are concerned that they will not be able to obtain
the necessary permission from their existing lender. It has been suggested that they
might show the land and buildings at their revised valuation in order to reduce the risk
of being in default of this covenant.
(i) Identify the figures that would be affected in Gander plc’s draft balance sheet
if the directors decide to incorporate the revaluation of the land and buildings
and recalculate the affected figures. [4]
(ii) Calculate the company’s gearing ratio using both the draft balance sheet
provided above and the revised figures according to the answer produced in
(i), and assuming that the company borrowed the further £30m early in the
new financial year. [4]
(iii) Explain whether revaluing the company’s land and buildings is an appropriate
response to the problem created by the covenant in the existing loan
agreement. [6]
(iv) Discuss the advantages and disadvantages of revaluing non-current assets in

the balance sheet. [6]
[Total 20]

20 The directors of Merchant plc are considering a five year project that has been
proposed by the company’s sales director. A customer is about to sell a very
specialised milling machine that has become surplus to requirements. This type of
machine would cost tens of millions of pounds to buy new. Used machines are rarely
sold on the open market. The machine has an expected remaining useful life of five
years and has been checked and certified by an independent engineer.
The sales director proposes buying the used machine for £4 million and using it to
manufacture a new product for which Merchant plc owns some patent rights and
which cannot be manufactured in an economic manner without such equipment. The
sales director proposes taking out a five year lease on a factory building and using an
employment agency to provide labour for the five year period. The sales director
estimates that it would be necessary to invest a further £1 million at the start of the
first year in addition to buying the machine: a returnable deposit of £100,000 on the
factory, £200,000 for the first year’s lease, £400,000 for the opening inventory of raw
materials and £300,000 for the initial payment for labour.
The sales director has drafted the following budgeted annual income statement for the
project:
£m
Revenue 2.6
Raw materials (0.4)
Factory lease (0.2)
Labour (0.3)
Depreciation of machine (0.8)
Other running costs (0.5)
Profit 0.4
It is anticipated that materials, recurring lease payments and labour will be paid for
annually at the start of each year. Other running costs comprise the cost of electricity
and other operating costs and they will be paid for annually at the end of each year.
Revenues will be received at the end of the year in which they are earned.
At the conclusion of the project, the sales director anticipates that it will cost
£300,000 to dismantle the equipment and at that time it will be possible to reclaim
100% of the deposit paid to the factory owner.
The sales director has shown this proposal to a potential lender, who has agreed to
lend Merchant plc £5 million at an interest rate of 7% p.a. This loan will be secured
on Merchant plc’s existing assets because the milling machine is deemed to be too
specialised to be a suitable form of security.
The sales director proposes that the project should be evaluated at a required rate of
return of 7% p.a. because it will be financed by means of a self-contained loan
package upon which that rate will be charged. The finance director believes that the
project should be evaluated at a much higher rate than 7% p.a., but cannot state the
specific rate that should be charged without conducting a further analysis.
CT2 A2010—8
The finance director is also concerned that the sales director has ignored tax when
preparing the budgeted income statement.
(i) Calculate the net present value of the project using a discount rate of 7% p.a.
and ignoring tax. [8]
(ii) Explain why the required rate of return might be higher than the 7% rate
charged by the bank on the funding for the project. [6]
(iii) Explain how adjusting for tax will affect the analysis of this project. You are
not required to calculate the effects of tax. [6]
[Total 20]
END OF PAPER
CT2 A2010—9
EXAMINERS’ REPORT
April 2010 Examinations

Core Technical
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
R D Muckart
Chairman of the Board of Examiners
July 2010
Comments
These are given in italics at the end of each question.
© Institute of Actuaries
Subject CT2 (Finance and Financial Reporting Core Technical) — April 2010 — Examiners’ Report
1 B
2 A
3 D
4 D
5 A
6 A
7 A
8 C
9 A
10 A
Questions 1–10 were answered well by most candidates.
11 (a) Information asymmetry arises because the directors know more about the
management of the company than its shareholders. The directors can also have
greater confidence in the figures at their disposal because they can check the
underlying data and the manner in which the information has been prepared.
(b) Financial reporting is a vital part of assuring the shareholders that the
company is being managed properly and in their best interests. The directors
will normally be keen to signal that the figures have been prepared accurately
and in accordance with acknowledged accounting standards. Publishing
credible financial statements will simplify the process of dealing with
shareholders.
The external financial statements are likely to be subject to an independent

external audit to further enhance the credibility of the accounts.
Part (a) was answered poorly with many candidates not showing any understanding of the
term at all, however part (b) was answered very well with most candidates scoring high
marks.
12 (a) The discount arises because the investment trust will charge an annual
management fee. The net present value of that should be deducted from the
underlying assets held by the trust in order to establish the investment trust’s
true value to the shareholder. It is also possible that the investment trust will
be slightly less marketable than the large quoted companies in which it has
invested and so the discount will be increased still further. Other reasons may
include natural sellers, aging population, illiquidity and a proliferation of
similar investments.
(b) The discount should not deter investors. If they buy existing shares in an
established investment trust then their initial investment will take advantage of
the discount. Even if they buy directly from the company it will be more
practical for an investment trust to spread the risk and diversify than it would
Page 2
be for many individual investors. Furthermore, the investment trust will

provide management expertise that will either reduce the risk of a costly
mistake or will offset the cost of paying for advice. Other reasons include
lower total expense ratios, audited accounts requirements, a wider range of
investment specialisms and gearing
This question was answered well by many candidates.
13 Warrants provide lenders with an opportunity to enjoy future increases in the share
price. That is a valuable benefit that can be added to the interest earned from the loan
stock, so the interest rate charged can be reduced. That will save cash and provide the
company with a better cash inflow in order to finance growth. The benefit will be
enhanced by the fact that the downside risk is restricted to the relatively small value
that will be attached to the warrant. The lender’s principal will almost certainly be
secured and so outright loss is highly unlikely.
The main problem faced by the shareholders is that the warrants will dilute their
equity in the event that the lenders exercise their rights to buy shares. If the project is
successful then the lenders will share in the gain and so the shareholders will earn less
from taking the ultimate risk.
Some candidates appeared not to know what warrants were while others gave a very
complete answer.
14 A rights issue is targeted at shareholders who have already demonstrated their

willingness to invest in the company. That reduces the cost of promoting the issue and
identifying suitable investors.
If the shareholders do not wish to take up their rights then the rights themselves have
a value and the shareholders have an incentive to sell them. The buyers are likely to
take up the right to subscribe to the offer, which reduces the need to underwrite the
issue.
The fact that the rights issue automatically compensates the shareholders for the
effects of the discount means that it is generally an equitable and acceptable method
of generating fresh equity. That makes rights issues more acceptable to the stock
market than other methods for an established company to issues further shares.
This question was answered very well by most candidates.
15 The basis on which the simulation has been prepared and tested should be studied
closely. The apparent success rate could be due to an error in the specification of the
model.
The results in the 15% of the time that the project returned a negative net present
value must be studied closely. Is there a significant downside risk that should be
Page 3
considered? A project that carries a realistic probability of the company being forced
into liquidation might be best avoided even if it has a significant probability of
success.
The anticipated income from the project should also be taken into account. If the
likely NPV is a small positive then that might not be sufficient to justify the
possibility of a loss.
Ultimately, the directors should consider the distribution of likely outcomes rather
than simply look at the most likely.
16 The cash flow statement indicates how the company has managed inflows and
outflows of cash during the year. A comparison of the opening and closing balance
sheets will indicate whether the company has more or less cash at the end of the year
than at the beginning, but that comparison does not indicate what has happened in
order to bring about that increase or decrease. The cash flow statement shows how the
company has both generated cash receipts and made payments.
The cash flow statement also indicates an important performance measure. Arguably,
it is more important to generate profit than to earn cash, but profits are not sufficient
to keep a business afloat unless they are backed by net cash receipts. A profit can be
recognised long before the company has any cash to show for it and the company will
have to meet its commitments in the period before the cash is actually received.
This question was answered poorly by some candidates. Candidates appeared not to
have learnt the format of the cash flow statement.
17 There is a general requirement that the financial statements give a true and fair view.
Amongst other things, that any treatment gives a realistic and representative treatment
of the transaction. It cannot be accounted for in a flattering way just because it is not
the subject of a specific regulation.
In the UK, FRS 18 gives some guidance as to how the policy should be selected. For
example, the objectives of relevance, reliability, comparability and understandability
should be applied.
The directors might consider looking at the treatment laid down by standards for
similar balances, even though those standards might not be strictly applicable. That
would ensure that the logic underlying the chosen treatment was consistent with good
accounting practice.
Page 4
18 Preparing financial statements involves making estimates and assumptions. For

example, inventory is valued at the lower of cost and net realisable value. The
directors can bias such assumptions towards maximising profit without doing so to the
extent that any dishonesty can be proven.
The selection of accounting policies is subject to accounting standards, but there are
often cases where the transactions or balances are not directly governed by any
specific standard. For example, the recognition of revenue can be quite a difficult area
of accounting. The board could start to recognise profits at a time that can be justified
without that necessarily being the most appropriate in terms of good accounting
practice.
This question was answered poorly.
The accounting policies are a common question. Generally the more theoretical questions
were not answered as well as questions involving calculations.
19 (i) The book value of property, plant and equipment would increase, as would the
revaluation reserve.
Property, plant and equipment would be increased to £200m+90m = £290m.

The revaluation reserve would be £90m.
(ii) Gearing (original figures) = (£50m+30m)/(161m+50m+30m) = 33%
Gearing (with revaluation) = (£50m+30m)/(161m+90m+50m+30m) = 24%
(iii) The revaluation means that the company would be in technical compliance
with the covenant. However, the purpose of the covenant is to ensure that the
company’s borrowings are manageable and that the interests of the lenders are
not prejudiced. The revaluation has the effect of altering the figures from
which gearing has been calculated, but that does not generate any additional
cash from which to meet the company’s commitments.
Borrowing heavily, using the revaluation of assets as a basis for doing so, will
threaten the equity invested by the shareholders. The more heavily that the
company borrows the greater the risk that the company will be unable to meet
its commitments. If the company goes out of business then the assets that have
been revalued may have to be sold under duress and that might mean that the
revalued sum will be impossible to realise.
It would be more satisfactory for the directors to decide that the company is
already heavily geared and seek some way to generate additional funds from
equity.
(iv) The revaluation of assets gives shareholders a more realistic impression of the
resources that they have placed at the disposal of the directors. That gives
them a clearer impression of the performance of their board in generating
wealth from the company’s assets.
Page 5
Revaluation should also give a clearer indication of the assets that will actually
be available in the event that the company runs into difficulty. Keeping the
assets at their valuation may be helpful to potential lenders when evaluating
the assets that have been pledged as security.
Valuation increases the subjectivity in the financial statements. Any valuation

is only ever an opinion as to how much the assets are actually worth, but the
validity of that assumption can only be tested by selling the asset and seeing
whether it can be sold for that amount.
Valuing assets also introduces some volatility into the balance sheet because
the valuations must be kept up to date. The asset may have to be written down
if market prices fall.
In general the larger questions were answered poorly compared to the shorter questions.
Part (iii) was answered well by many candidates. Part (iv) was answered very badly with
some candidates not doing this part of the question.
20 (i)
Time 0 1 2 3 4 5
Revenue 2.6 2.6 2.6 2.6 2.6
Machine (4.0)
Factory deposit (0.1) 0.1
Lease payment (0.2) (0.2) (0.2) (0.2) (0.2)
Inventory (0.4) (0.4) (0.4) (0.4) (0.4)
Labour (0.3) (0.3) (0.3) (0.3) (0.3)
Running costs (0.5) (0.5) (0.5) (0.5) (0.5)
Dismantling (0.3)
Cash flow (5.0) 1.2 1.2 1.2 1.2 1.9
Discount factor 1.000 0.935 0.873 0.816 0.763 0.713
Discounted cash flow (5.0) 1.1 1.0 1.0 0.9 1.4
Net present value = total = £0.4m

Cash flows
Discounted cash flow
NPV
(ii) The cash flows should be assessed in terms of the risk attached to the project.
The risks borne by the company and its shareholders are not mirrored by those
borne by the lender. The risks to the company are based on the possibility that
the project will not generate a satisfactory return in line with expectations,
which has nothing to do with the risk that the bank will not be repaid on time
Page 6
or in full. The bank will secure its advance against the company’s other assets,
which will increase risks to the existing providers of finance. The loan will
push up the cost of equity and so the real cost of the finance to the company
will be higher than 7%.
(iii) Tax will reduce the net cash inflow from the project.
The timing of payments will also be affected because tax is often paid for in
arrears, which means that the tax bill for year 5’s profits will probably be paid
in year 6. That might mitigate the effect of the additional outflows arising
from the tax on profits from the project.
Tax calculations will complicate the analysis and increase the risk associated
with the figures. There is a possibility that the tax authorities will not agree
with the tax calculations prepared by the company and that some expenses will
not be permitted. The time spent negotiating the tax bill will create additional
outflows for professional fees and may also prove to be a distraction from
other projects.
Allowing for tax may affect the cost of capital because tax relief will be
obtained on the loan.
This question was answered badly by many candidates. The main difficulty was part (i)
where candidates did not understand what a cash flow was or what should go into it.
It should only have items that involve the movement of money.
Parts (ii) and (iii) were answered a little better but were still poor.
END OF EXAMINERS’ REPORT
Page 7
EXAMINATION
11 October 2010 (am)

Core Technical
booklet.
supervisor.
question paper.
CT2 S2010 © Institute of Actuaries
correct.
1 Which of the following best describes the role of the stock market in motivating
company directors to make sound decisions?
A A badly managed company can be identified by comparison to other quoted

companies.
B A badly managed company may have its stock market quotation suspended.
C A badly managed company will have a low share price and it may be possible
to buy a controlling interest and replace the board.
D A badly managed company will report poor profits and the shareholders will
complain.
[2]
2 Which of the following statements best explains why a company’s shareholders are
prepared to tolerate the risks associated with raising additional funds through
borrowing?
A If the company fails then the lenders will bear the burden of loss.
B Shareholders are capable of creating their own gearing if they so wish.
C Tax relief on interest reduces the cost of borrowing, which offsets the effects
of the additional risk associated with borrowing.
D The shareholders do not bear the risks directly because they are borne through
the company itself.
[2]
3 Which of the following might be classified as a systematic risk?
A A major customer could switch to a different supplier.

B A major product could be deemed to be unsafe.
C Interest rates might decrease.
D The chief finance officer could be fraudulent.
[2]
CT2 S2010—2
4 A company has had a long-established policy of reinvesting profits in order to finance
expansion, but has reached a stage of maturity where it does not need to retain equity
and so it has announced that it will pay substantial dividends. Which of the following
describes the most likely response of the capital markets to such a change?
A The share price will decrease in the short term, but will return to previous
levels as the market becomes accustomed to the new dividend policy.
B The share price will increase in the short term, but will return to previous
levels as the market becomes accustomed to the new dividend policy.
C The share price will decrease in the short term and the decrease will persist.
D The share price will increase and that increase will persist.
[2]
5 Which of the following accounting concepts can be used to justify carrying a non-
current asset at its historical cost less depreciation even though this is not a
particularly relevant figure for most decisions?
A accruals
B going concern
C prudence
D realisation
[2]
6 Which of the following best describes depreciation?
A An annual accounting adjustment that has no real purpose.

B A process of correcting the balance sheet to make valuations more relevant.
C A process of reflecting market values for depreciating assets.
D A process of writing the cost of an asset off over its useful life.
[2]
7 Which of the following could cause the earnings per share figure to be diluted?
A a decline in revenues
B a loss on the revaluation of an asset
C the correction of an accounting estimate
D the issue of a convertible bond
[2]
CT2 S2010—3 PLEASE TURN OVER

8 Which of the following best describes the purpose of a cash flow statement?
A to forecast future inflows and outflows of cash

B to show historical inflows and outflows of cash
C to show the company’s financial position
D to show the company’s profitability
[2]
9 A company has to choose between two competing projects. Which of the following
decision criteria will definitely maximise shareholder wealth?
A Choose the project that has the lower risk.

B Choose the project with the higher internal rate of return.
C Choose the project with the higher net present value.
D Choose the project with the shorter payback period.
[2]
10 Which of the following best explains the use of maximisation of shareholder wealth
as the basis for finance theory?
A All shareholders are greedy.
B It provides a single, clear criterion against which success or failure can be

measured.
C The shareholders require a return for investing.
D The shareholders require protection from the directors’ ambitions.

[2]
11 Explain why a small business should take great care in managing its overdraft. [5]
12 National tax systems often have the objectives that the tax burden is fair and
reasonable. Explain how these objectives are achieved. [5]
13 Explain why Eurobonds tend to offer investors a higher rate of return than traditional
loan stock. [5]
14 Explain why a company’s gearing ratio calculated from the company’s annual
accounts might not be sufficient on its own to provide an interested party with an
understanding of its capital structure. [5]
15 A company’s directors are considering the implications of two downside risks that
might affect a project. One of the risks has a 20% probability of occurrence and will
CT2 S2010—4
reduce the net present value of the project by £1m if it does. The other risk has a 1%
probability of occurrence and will reduce the net present value of the project by
£20m. The company’s market capitalisation is presently £100m.
Explain why it would not be acceptable to treat these risks as being equivalent to one
another because each has an expected value of £200,000.
[5]
16 (a) Explain the implications for the weighted average cost of capital if a
company’s ordinary share price decreases.
(b) Explain how this will affect the company’s strategy for investing in capital
projects.
[5]
17 Explain the likely implications that will arise from a company preparing financial
statements which do not comply with relevant accounting standards and the external
auditor reporting that failure to comply in the audit report. [5]
18 Alpha is a quoted company. The company’s directors consistently choose optimistic

accounting policies in the belief that doing so increases their share price.
Explain why it is unlikely that the share price will be overstated by this practice. [5]

19 The directors of Real plc are considering an investment in a project that has a positive
net present value. This will involve borrowing £4m on 1 October 2010 and investing
£3m in a new piece of machinery on that date and spending the remaining £1m on raw
materials during the two months before the year end of 31 December 2010. There
will be no production from the machine in 2010.
The new equipment is expected to have an estimated useful life of five years with no
residual value. Real plc depreciates equipment using the straight line method, with a
full year’s depreciation charged in the year of acquisition.
Interest will be charged on the loan at a rate of 8% per annum, with the first interest
payment due on 30 September 2011.
Entering into this series of transactions will have no effect on the tax charge for the
year ended 31 December 2010.
Before the directors became aware of this investment opportunity they prepared the
following forecast financial statements:
Real PLC
Forecast Income statement for the year ended 31 December 2010
£000
Revenue 20,000
Cost of sales (12,000)
Gross profit 8,000
Distribution costs (1,200)
Administrative expenses (400)
Operating profit 6,400
Finance costs (632)
Net profit before tax 5,768
Tax expense (1,500)
Profit for the year 4,268
Real PLC
Forecast balance sheet as at 31 December 2010
£000
ASSETS
Non-current assets
Property 10,000
Plant and equipment 11,000
Total non-current assets 21,000
Current assets
Inventories 500
Trade receivables 1,667
Bank 10
2,177
Total assets 23,177
CT2 S2010—6
Equity
Share capital 10,000
Retained earnings 4,677
Total equity 14,677
Long-term borrowings 6,000
Current liabilities
Trade payables 1,000
Current tax payable 1,500
2,500
Total liabilities 8,500

Total equity and liabilities 23,177
(i) Restate the forecast financial statements to incorporate the effects of the
investment on the company’s income statement and balance sheet. [5]
(ii) Compare and contrast, using ratio analysis, the figures according to the
original financial statements with those prepared in your answer to (i) above.
Your analysis should cover the areas of profitability, liquidity and efficiency.
[9]
(iii) Use your answer to (ii) above to explain why the need to publish annual
financial statements might discourage company directors from investing in
positive net present value projects. [6]
[Total 20]

20 Koolclean plc was founded several years ago by the inventor of an innovative
consumer product. The product has been very successful in the UK and the inventor
has decided to seek a quote on the Alternative Investment Market (AIM). At present
60% of Koolclean plc’s shares are held by the inventor and the remaining 40% are
held by a venture capitalist who is keen for the company to list in this way so that his
block of shares can be sold.
The company has been managed by the inventor herself, assisted by a part-time
director appointed by the venture capitalist. The part-time director will step down
when the venture capitalist’s block of shares is sold.
The inventor is keen to appoint an experienced management team and has decided to
offer a remuneration package that comprises a fairly large number of share options
and a relatively small salary in order to attract a particular type of manager.
Koolclean plc has published audited financial statements every year since it was
incorporated. The inventor has decided to replace the company’s audit firm with one
that is larger and more experienced in auditing the financial statements of quoted
companies.
(i) Explain the advantages and disadvantages of seeking the initial funding for a
new business in the form of equity from a venture capitalist rather than
borrowing. [6]
(ii) Explain the agency issues that are likely to arise from paying the new directors
with share options rather than salaries. [8]
(iii) Describe the external auditor’s role in protecting Koolclean plc’s

shareholders’ interests after it obtains its quotation. [6]
[Total 20]
END OF PAPER
CT2 S2010—8
INSTITUTE AND FACULTY OF ACTUARIES
EXAMINERS’ REPORT
September 2010 examinations

Core Technical
Introduction
T J Birse
December 2010
© Institute and Faculty of Actuaries

Subject CT2 (Finance and Financial Reporting Core Technical) — September 2010 — Examiners’ Report
1 C
2 C
3 C
4 B
5 B
6 D
7 D
8 B
9 C
10 B
11 Overdraft facilities are repayable on demand. If the facility is not managed properly
then there is a risk that the bank will demand immediate repayment and that could
have severe consequences for the company. The bank might also use the overdraft
facility as a means of monitoring the business’ financial health and any excessive
reliance could undermine the business’ credit rating. It is also undesirable to use
overdrafts extensively because they are very expensive. It would be preferable to use
a short term loan to replace the overdraft. Doing so would also free some of the
overdraft facility to provide cover for contingencies.
12 Tax systems often focus more heavily on income rather than wealth, which means that
taxpayers are more likely to be asked to pay a tax bill that is based on cash flows
rather than other assets that might not be liquid. Tax charges are usually levied in
arrears, so that the income has been earned before it is taxed. Tax systems often
attempt to ensure that income is taxed only once, for example double tax relief
reduces the chances of the same income being taxed by two separate regimes and
similarly imputation systems are often designed to ensure that income tax is not paid
on dividends that are paid out of profits on which corporate tax has been paid.
Tax systems also tend to feature tax free allowances and also accelerating rates, which
makes them progressive and means that those who can afford to pay at a higher rate
actually do so.
13 The main reason for paying a higher rate is that Eurobonds are issued outside of any
legal jurisdiction. That lack of regulation increases the risk to the lender. Eurobonds
tend to be unsecured, which increases the risk even further. Eurobonds are traded
through banks rather than stock exchanges, which further reduces the scope for
regulation. Eurobonds tend to be used to raise large amounts of money, and so a
higher rate will make it easier to ensure that the issue is taken up.
Page 2
14 There are qualitative factors that should be considered. For example, the life of
borrowing should ideally be matched to the maturity of the associated assets. A
medium term loan taken out to finance long term assets might have to be serviced out
of cash flows from other projects.
Some companies need to have the flexibility to draw down funds when needed but
repay loans when activity tails off. That type of facility will also be a factor in
deciding whether the debt that has been borrowed is of the correct nature for the
business.
There may be times when the risks associated with gearing are dwarfed by the risks of
standing still and not borrowing in order to adapt to changing circumstances. The
gearing ratio does not necessarily reflect the company’s appetite for funds.
15 Managing project risks should take account of far more than the expected value of the
risks. For example, the 20% risk is fairly likely to occur and its effects will not be
catastrophic if they do. In that case, it would make more sense to accept the risk
provided the NPV from the project offers sufficient compensation for the risk of
losing £1m. The high probability of occurrence probably means that any alternative
approach would be too expensive to consider.
The 1% risk is potentially catastrophic because it would erode 20% of the company’s
capitalisation. The low probability of occurrence probably means that it would be
possible to hedge or insure in some way so that the risk can be avoided. If that is the
case then the cost of the insurance will be taken on board in evaluating the project.
16 (a) If the share price falls then the market is effectively demanding that the profits
earned by the company are capitalised at a higher rate of return. In other
words, the cost of equity is increasing.
(b) If the share price is declining then there is a need to find positive NPV projects
in order to halt the decline, but the board has to ensure that the cost of equity is
at least met by these prospective investments. It may be that the directors have
to cancel some projects that had previously been planned or reject proposals
that would once have been funded.
The communication of the risks and rewards may also have to be managed
more carefully. Management may have to convince shareholders that they are
achieving good value from their investments.
Page 3
17 The most immediate implication might be that market forces would discipline the
company quite severely. Shareholders and other users might feel that the use of
unacceptable accounting policies meant that the directors had something to hide,
which would push share prices down and could push up interest rates. Some lenders
might argue that the company is technically in default of debt covenants based on
accounting numbers and they might even foreclose on the company.
There could be more direct action by regulators such as the stock exchange or other
regulators.
18 The stock market sifts information carefully to ensure that it does not misprice
securities. If shares are overpriced then there will be opportunities for astute market
participants to make profits by identifying the overpriced companies and selling
shares (possibly short). Market forces would push the shares down and these activities
would also draw attention to the distortion.
Much of the optimism in making accounting choices is quite visible. For example,
companies publish their accounting policies and so it is possible to tell whether a
particular approach has been followed.
19 (i)
Real PLC
Forecast Income statement for the year ended 31 December 2010
£000
Revenue 20,000
Gross profit 7,400
Administrative expenses (400)
Operating profit 5,800
Finance costs (712)
Net profit before tax 5,088
Tax expense (1,500)
Profit for the year 3,588
Page 4
Real PLC
Forecast balance sheet as at 31 December 2010
£000
ASSETS
Non-current assets
Property 10,000
Plant and equipment 13,400
Total non-current assets 23,400
Current assets
Inventories 1,500
Bank 10
3,177
Total assets 26,577

Equity
Total equity 13,997
Long-term borrowings 10,000
Current liabilities
Accrued interest 80
Current tax payable 1,500
2,580
Total liabilities 12,580
Total equity and liabilities 26,577
Page 5
(ii)
Original figures With investment

Profitability
Return on capital employed 6,400/(14,677+6,000) = 31% 5,800/(13,997+10,000) = 24%
Gross profit percent 8,000/20,000 = 40% 7,400/20,000 = 37%
Liquidity
Current ratio 2,177/2,500 = 0.9:1 3,177/2,580 = 1.2:1
Quick ratio 1,677/2,500 = 0.7:1 1,677/2,580 = 0.7:1
Efficiency
Inventory turnover 500/12,000 × 365 = 15 days 1,500/12,600 × 365 = 43 days
Making this initial investment will increase the recorded cost of depreciation
because of the company’s policy of charging a whole year’s cost when an
asset is new and also increase the cost of interest because of three months’
interest on the new loan. The reduced profit combines with the increased
capital employed to yield a much lower return on capital employed. Overall,
the company seems much less profitable than it would without the investment.
The company’s liquidity will be affected by the increase in inventory, which

has the effect of making the current ratio appear higher and less efficient. That
combines with the much slower apparent inventory turnover to make the
directors look as if they are not properly managing inventory.
If the directors do undertake this investment then they will have to ensure that
the shareholders are adequately informed that the figures have been affected
by the need to put the funding in place for the new project and also by the
decision to install equipment and stockpile inventory ready for the start.
(iii) A year can be a very short period for a business that has a profit cycle of
several years. For example, it might take three years to research a new
product, which will then sell strongly for five years before becoming less
popular. The danger is that profits will be depressed during the research phase
of that cycle. If the directors do not trust the shareholders to appreciate the
reasons for that then there is a risk that they will not invest adequately in
development.
The same problem can arise with any investment programme. If the initial
investment is made part of the way through the year then the balance sheet
will show the closing position on capital employed and the directors will
appear to have had those resources at their disposal when returns are being
evaluated. The project may not have started during the year or it may have
been in operation for only a short part of the year and so ratios such as return
on capital employed will make the company seem inefficient.
20 (i) The venture capitalist will have a very similar interest in the survival of the
company as the founder. A lender might be prepared to put the company out
of business, but a venture capitalist may lose everything in that case. The
Page 6
venture capitalist’s equity will also leave scope for borrowing if required,
thereby providing scope for greater flexibility in seeking fresh funding.
The venture capitalist is likely to seek an exit route in the medium term to
release funds that can be reinvested elsewhere. That could mean that the
company has to fund a major outflow at a crucial stage of its development.
The other major problem is that the venture capitalist will be looking for a
realistic price for the shares when they are bought out. If the company has
prospered then the cost of releasing the equity may be prohibitive.
(ii) Share options give the directors an incentive to maximise the share price. That
may have the effect of bringing their interests into line with those of the
shareholders. The directors will have an incentive to work hard and use their
ingenuity in order to create wealth for the company.
There are some dangers with options, though. The directors will need the share
price to exceed the strike price before the options expire. That could give them
an incentive to push the company’s growth too quickly or even to distort the
share price by manipulating the financial statements. The options also expire
worthless, so the directors will have very little to lose if the options are out of
the money and they decide to take a major risk. If the risk pays off then the
options will be in the money and if not then the options would have been
worthless anyway, but that will be of no consequence to the shareholders.
The value of the options will be enhanced if the company’s share price
becomes more volatile. The shareholders might prefer a less volatile (i.e. less
risky) investment.
(iii) The auditor is appointed by the shareholders and reports to the shareholders.
The external auditor has no specific duty to protect the shareholders interests.
The auditor forms an opinion on the truth and fairness of the financial
statements and reports that to the shareholders. If there are material concerns
about the financial statements then they should be reported to the shareholders
in the audit report.
The purpose of the audit is to ensure that the shareholders have a credible
source of accounting information that they can use to make stewardship
decisions. The auditors do not claim to identify badly run or unprofitable
companies. It is up to the shareholders to make such decisions for themselves,
informed by the audited financial statements as they deem appropriate.
Page 7
EXAMINATION
21 April 2011 (am)

Core Technical
booklet.
supervisor.
question paper.
CT2 A2011 © Institute and Faculty of Actuaries

correct.
1 Which of the following best describes the concerns arising from the agency
relationship in companies?
A The directors may act in their own interests at the expense of those of the
shareholders.
B The shareholders may have different interests from one another.
C The directors may be unwilling to consider the company’s duties to society.
D The directors may put the interests of lenders before those of the shareholders.
[2]
2 Which of the following best describes the potential exposure of a member of a limited
liability partnership (LLP)?
A Members of an LLP are not exposed to any risk of loss.

B The LLP itself could fail, costing each member his or her stake in the business.
C Each member is personally liable for his or her share of the LLP’s liabilities.
D Each member is jointly and severally liable for the liabilities of the LLP.
[2]
3 A company has 10 million ordinary shares in issue with a market price of £2.00 per
share. The company is about to make a rights issue that will give the right to buy one
new share for £1.60 for every five shares previously held. What is the theoretical ex-
rights price of the company’s shares?
A £1.60
B £1.80
C £1.93
D £2.00
[2]
4 Which of the following best explains why a bonus issue of shares may imply
confidence on the part of the directors?
A The bonus issue is only possible because of past success.
B Reducing the market price per share may have an impact on the company’s
ability to issue new shares in the future.
C Shareholders have a right to the same dividend per share on an increased

number of shares.
D The bonus issue will increase the gearing ratio.

[2]
CT2 A2011—2
5 Which of the following situations is best suited to the purchase of a currency option?
A The buyer wishes to gain from any change in future exchange rates.
B The buyer wishes to eliminate all future uncertainty.
C The buyer wishes to determine the “worst possible” outcome.
D The buyer wishes to determine the “best possible” outcome.
[2]
6 Which of the following statements best describes the role of accounting standards in
the preparation of financial statements for publication?
A Accounting standards have little impact on the process of preparing financial

statements.
B Accounting standards provide companies with a broad indication of what the

financial statements should contain.
C Accounting standards reduce variations between companies in the way they

prepare accounts.
D Accounting standards eliminate all scope for disagreement over accounting.

[2]
7 Which of the following accounting concepts provides justification for the fact that
book values of certain assets may not always reflect their true value?
A business entity
B going concern
C money measurement
D realisation
[2]
8 An item of equipment cost £5,000 and has an estimated useful life of ten years, at
which time it is anticipated that it will be scrapped and sold for £200. The machine is
now three years old. What is this machine’s book value if the company uses the
straight-line method of depreciation?
A £3,360
B £3,440
C £3,500
D £3,560
[2]

9 Which of the following best describes the parent company / subsidiary company
relationship?
A A subsidiary company is wholly owned by its parent.

B A subsidiary company is largely owned by its parent.
C A subsidiary company is influenced by its parent.
D A subsidiary company is controlled by its parent.
[2]
10 Over a particular period, a company’s profit before tax was £700,000. Share capital is
£400,000 and retained earnings are £470,000. Long term liabilities are £600,000.
Interest on long term liabilities was £48,000.
What was the company’s return on capital employed for the period described above?
A 48%
B 51%
C 75%
D 86%
[2]
11 Comment on the suggestion that the interests of shareholders and lenders can conflict.
[5]
12 Simon established an actuarial practice several years ago. The business has been
successful. One of Simon’s longest-serving actuaries has started to look for
alternative employment and Simon is considering offering her a partnership in the
practice.
Discuss the implications for Simon of making this employee a partner. [5]
13 Explain why preference shares are generally accounted for as debt rather than equity.
[5]
14 Explain why tax legislation does not permit depreciation as an expense for tax
purposes but grants a capital allowance instead. [5]
15 Comment on the assertion that the internal rate of return method has no advantages
over the net present value method of evaluating investment opportunities and has
several disadvantages. [5]
CT2 A2011—4
16 (a) Identify two accounting concepts.
(b) Explain how each assists in the preparation of financial statements.
[5]
17 The external auditor’s report for company Z Ltd consists of a disclaimer of opinion.
(a) Explain what is meant by such an audit report.

(b) Describe the circumstances for which it might be appropriate.
[5]
18 The directors of a quoted company have the opportunity to invest in a profitable

project, but will be unable to raise sufficient finance in the required timeframe unless
they substantially reduce the next dividend payment compared with that paid in
previous years.
Discuss the implications of reducing the dividend under these circumstances. [5]

19 Harris is a manufacturing company that has recently developed a new product that is
likely to be a major commercial success. Harris must raise £8m in order to put this
product into production. The company’s most recent statement of financial position is
as follows:
Harris
Statement of Financial Position as at 31 March 2011
£m
Assets
Property, plant and equipment 22
Current assets 3
25
Equity
Share capital 8
Retained earnings 5
13
Liabilities
Non-current liabilities 11
Current liabilities 1
25
Property, plant and equipment comprises £10m of land and buildings and £12m of
manufacturing equipment. All of Harris’ non-current assets are valued at cost less
depreciation.
Harris had its land and buildings revalued as at the year end. The valuer’s report
indicated that the buildings were of a specialised nature, but that the property could
nevertheless be marketed for approximately £17m.
Non-current liabilities comprise a bank loan that has a covenant in place that forbids
Harris from taking out further borrowings that would increase the company’s gearing
ratio (measured as debt over debt plus equity) to more than 50%.
(i) Explain why a bank might be interested in a borrower’s gearing ratio. [4]
(ii) Calculate Harris’ gearing ratio under each of the following conditions:
• using the unadjusted figures according to the most recent statement of

financial position
• assuming that Harris had borrowed the £8m required to fund the expansion
• assuming that Harris had borrowed the £8m required to fund the expansion
and that the company had revalued its land and buildings in accordance
with the valuer’s report [6]
(iii) Explain why the directors of limited companies are likely to take great care
when deciding whether to revalue property. [5]
(iv) Explain why the shareholders might prefer to have the property revalued
rather than shown at cost less depreciation. [5]
[Total 20]
CT2 A2011—6
20 Porter is a quoted company which operates a fleet of trucks and provides a transport
network for a number of very large businesses, such as food manufacturers who need
to make bulk deliveries to supermarket chains.
The company is considering investing in a risky new project. Many of the goods
transported by the company arrive by ship and most major ports have rail links which
make it possible for shipping containers to be loaded directly on to trains. Porter is
considering creating an “inland port”, which will involve buying a large piece of land
in the centre of the country, adjacent to a major railway line which can be accessed by
rail from several ports. Goods arriving by ship for Porter’s customers will be taken by
rail to this inland port facility where they will be offloaded from trains and on to
trucks. The trucks will then take the goods directly to their final destination.
The cost of establishing this facility will be substantial, but it will offer a faster and
more efficient service. Porter will save huge amounts of money and fuel. The use of
this method will also reduce emissions and so products transported in this way will
have a much lower carbon footprint.
There are some significant risks associated with this proposal. It will be difficult to
recruit and retain sufficient drivers to work from the new location. The company will
be exposed to the health and safety risks that are presently borne by the port operators.
The IT systems may not cope with the volumes of time-critical data that will have to
be processed in order to keep containers moving efficiently. Any disruption to either
the road or rail networks, perhaps due to bad weather, will have an impact on
performance.
Porter will have to borrow heavily in order to finance the investment. If the inland
port is not a commercial success then Porter may not survive as an independent entity.
The directors have estimated that there is a 25% chance of commercial failure of the
project.
The project has a beta of 0.55. The risk free rate is 4% p.a. and the equity risk
premium is 9% p.a. The project offers an estimated return of 26% p.a.
(i) Calculate the required rate of return for the project. [2]
(ii) Explain how an apparently risky project can have a relatively low required rate
of return. [7]
(iii) Discuss the factors that will affect Porter’s share price on the announcement of
its intention to invest in the project. [6]
(iv) Discuss the factors that may deter the directors of Porter from investing in the
project, even if they are confident that the shareholders would wish them to
proceed. [5]
[Total 20]
END OF PAPER
CT2 A2011—7
EXAMINERS’ REPORT
April 2011 examinations

Core Technical
Introduction
T J Birse
July 2011

Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, April 2011
General comments
This exam had some excellent results. There was a high pass rate and some candidates
scored highly.
The parts of the exam which were done poorly tended to be the finance sections rather than
the accounting questions. Most candidates who intend resitting are likely to benefit from
concentrating their revision on the finance topics.
The answers to the questions were mixed, some were excellent but others, particularly
questions 13, 15, 17, and 19 were poor.
Page 2
1 A
2 B
3 C
4 B
5 C
6 C
7 B
8 D
9 D
10 B
Working for q3:

Market capitalisation = £20m before rights issue + (2m × 1.60) = £23.2m for 12m shares =
£1.93/share 9
Average price = £1.80
Workings for q8:

Correct answer = 5,000 – ((5,000 − 200)/10 × 3) = 3,560 9
Ignore residual = 5,000 – ((5,000)/10 × 3) = 3,500
Add residual = 5,000 – ((5,000 + 200)/10 × 3) = 3,440
Subtract residual from cost = (5,000 – 200) − ((5,000 − 200)/10 × 3) = 3,360
Working for q10:

Correct answer = (700,000 + 48,000)/(400,000 + 470,000 + 600,000) = 51%
Wrong return = 700,000/(400,000 + 470,000 + 600,000) = 48%
Exclude retained earnings = (700,000 + 48,000)/(400,000 + 600,000) = 75%
Exclude liabilities = (700,000 + 48,000)/(400,000 + 470,000) = 86%
The MCQs were done very well by most candidates. No one question appeared to cause a
significant problem for candidates.
Page 3
11 The shareholders enjoy any profits after interest and tax and are keen to see the
company prosper. The lenders wish to have their agreed interest and repayments.
Neither party will necessarily benefit if the other suffers. If the company is unable to
repay its lenders then the shareholders may lose everything. If the company does not
make a profit then it may prove difficult to meet loan repayments.
There is a difference in risks, which could have an impact on the differences between
the shareholders and the lenders. The shareholders enjoy upside risks, whereas there
are no real upside risks for lenders. Thus, lenders may have no incentive to encourage
significant risk-taking on the part of the companies that they lend to. There may be
times when shareholders have very little downside risk. For example, if the company
is in difficulties then the shareholders may feel that there is little to be lost if the
company takes risks in order to deal with the problem. If the company is going to fail
anyway then the risks will cost them nothing if the risky strategies fail but the lenders
may suffer if the funds that would be used to meet their repayments are lost.
This question was done very well by many candidates.
12 Admitting a partner is a serious matter. The new partner will be entitled to an agreed
share of any profits, which could prove expensive to Simon. Simon will also be
jointly and severally liable with the new partner, even if the liabilities arise from an
act or omission on her part.
Presumably the new partner will be expected to buy her way into the equity and that
could generate long term funding for the business.
Granting a partnership should avoid the risk of this person leaving Simon’s practice.
That may be a good enough reason for the partnership in itself if Simon has become
dependent on this individual. She will also be more highly motivated by the fact that
she has a personal stake in this business.
This question was also done well with a number of candidates scoring full marks.
13 Preference shares are only equity in the legal sense of the relationship between the
company and the shareholder. Preference shares carry a fixed dividend, which has
exactly the same impact on the ordinary shareholders’ returns as borrowing. If the
preference dividend is suspended then the rights are likely to be carried forward, so
the dividend will be paid eventually. Shareholders are also likely to have additional
rights in the event that the preference dividend is in arrears.
Historically, preference shares have often been designed to avoid showing debt in the
statement of financial position. It has become important to show them as debt because
that has been the motive for issuing them.
This question was not done very well by candidates which was disappointing. Most
candidates got the points about the fixed dividend but few mentioned that a fixed
return was similar to debt.
Page 4
14 Depreciation requires highly subjective judgements that can be exploited to manage

the resulting depreciation figure. If depreciation could be charged as an expense then
the company could virtually determine its own tax charge.
Capital allowances are calculated in a consistent manner, so the tax authorities know
exactly what they will be. That avoids the risk that time will have to be spent
checking and evaluating the calculation.
The tax system can also permit the encouragement of investment. For example, the
initial rate can be as high as 100% in the first year, so that there is an additional cash
flow advantage from the tax system.
This question was done very well by many candidates. No significant problems were
noted at all.
15 The IRR criterion will give the same result as the NPV method in simple cases where
the only matter to be decided is whether to invest in a simple investment. The
disadvantage is that the computation is generally more complicated and requires trial
and error or a spreadsheet for an accurate measure.
IRR can be misleading when the decision is more complicated, such as deciding
between two investments. IRR makes no adjustment for the scale of the investment
and so it could lead to the wrong project being selected NPV always expresses the
result as an absolute value for the change in shareholders’ wealth. That means that the
impact of the investment is always visible.
This question was done poorly. This should have been a straightforward question as
it was knowledge based, however the level of knowledge shown was quite poor.
It is generally the finance questions that candidates do not answer adequately.
16 The money measurement concept requires that accounting statements restrict

themselves to matters which can be measured objectively in money terms. That
simplifies accounting enormously because it excludes such items as the values of the
company’s customer base, its work force and its brand names. Such assets could be of
huge interest to the shareholders, but they would be difficult to value and the
valuations would be open to challenge.
The going concern concept assumes that a business will continue indefinitely in its
present form. That justifies many of the limitations imposed by the cost concept
because there is little harm in reporting irrelevant figures for value if the assets
concerned are unlikely to be sold in the immediate future.
Any two concepts are acceptable.
This question was answered very well. Usually questions on the accounting
concepts are done very well and this was no exception.
Page 5
17 A disclaimer is an extreme form of modified audit report. Effectively the auditor

refuses to express an opinion on the financial statements because of uncertainty that is
so serious that it is impossible to form an opinion. In these circumstances, the auditor
believes that the financial statements cannot be used for decision making purposes.
This form of qualified report would be used in extreme cases where the evidence
available to the auditor is so deficient that it has led to extreme uncertainty. For
example, the auditor might disclaim opinion if the bookkeeping records had been
destroyed by a fire and no backups were available.
This question was probably the least well answered in the exam. Many candidates did not
know what a disclaimer report was. The level of knowledge of this area of the syllabus was
poor.
18 The markets are likely to read the reduction of the dividend as a sign that the company
is in difficulty. Companies always try to maintain a steady dividend policy in order to
demonstrate confidence.
The directors could attempt to limit the damage by stressing that the cash will be
invested in a positive NPV project. If the market accepts that argument then, at least
in theory, the share price may not be harmed to the same extent. The problem is that
this assurance may be misread as an excuse for cutting the dividend and may not be
fully believed or understood.
In any case, shareholders may be disadvantaged by this action because some will be
dependent upon the dividend payment.
This question was answered very well by most candidates, showing a clear
understanding of this topic.
19 (i) Gearing indicates the proportion of the long term finance provided by lenders.
If the gearing ratio is high then the banks will be competing with a larger
number of creditors for payment in the event of default. High gearing also
indicates that the company is at an increased risk of running into difficulties.
Banks often restrict the gearing ratio so that only a minimal amount of
additional borrowing is permissible. They track gearing closely in order to
check that the company is not in default because they would then have the
right to foreclose on the loan.
(ii) Gearing (original figures) = (£11m)/(13m + 11m) = 46%

Gearing (loan, unadjusted) = (£11m + 8m)/(13m + 11m + 8m) = 59%
Gearing (loan, adjusted) = (£11m + 8m)/(13m + 7m + 11m + 8m) = 49%
The calculations were done reasonably well.
Page 6
(iii) Revaluing property increases a company’s equity and so if the company has a
bank covenant in place, it may avoid the covenant conditions being breached.
The danger is that the revaluation does little to reduce the risks faced by the
shareholders and the company itself. There will be no additional cash flows
arising as a result of the revaluation and so the company will be no better
equipped to service the larger loan.
Relying on revaluation to support the a loan decision implies that a company

is willing to risk the loss of its property in order to proceed with the loan. If
that is the case then it may be of some reassurance to the lenders, but will do
little or nothing to comfort shareholders. There is no great advantage in
revaluing in order to comfort lenders because the accounting treatment does
not affect the fact that the asset’s value had increased.
This part of the question was answered quite well.
Most candidates understood that revaluing an asset would possibly help the
conditions of the bank’s covenant.
(iv) The most immediate implication from the shareholders’ point of view is that
revaluation makes the directors more accountable for the resources that have
been provided in order to generate wealth for the shareholders. When
calculating return on capital employed the revaluation reserve indicates the
full extent of the equity that has been entrusted to the board. If assets were left
at cost less depreciation then it would possibly make the company look more
efficient than it actually was.
Regular revaluations may also force the directors to ensure that they take
adequate care of the company’s assets. If they do not maintain the property or
pay attention to market trends then the shareholders may be concerned that the
company is not maintaining the property adequately or that the company is
retaining an investment in property in the face of a declining market.
This question was not answered very well as it called for application of
knowledge on revaluations. It required candidates to think carefully about
why assets are revalued and whether it is a good idea or not.
Page 7
20 (i) Required rate = 4% + (0.55 × 9%) = 8.95%
Most candidates got this calculation correct.
(ii) The total risk associated with an investment is not particularly important in the
context of a diversified portfolio. A significant proportion of the risk in most
investments can be diversified away. In other words, factors such as the risk of
IT failure or of the closure of the roads will be cancelled by portfolio effects.
Risk can be separated into two components: systematic and unsystematic.

Systematic risk is inherent in the political and economic environment and is
common to all companies. For example, a change in energy prices will affect
all companies to some extent. Unsystematic risk is specific to the company. It
encompasses a range of risks specific to the company such as changes in
market demand for its products, stability of industrial relations, nature and
location of its assets, and so on.
Systematic risk cannot be diversified away because it arises from factors

which will have an effect on all companies. Thus, an increase in interest rates
or oil prices is likely to have an adverse effect on all companies and will
depress returns from the market as a whole. Unsystematic risk can be
diversified away and, provided the investment is held in a properly diversified
portfolio, it can therefore be ignored.
It is possible that a highly speculative investment will not be affected by

general market conditions to any great extent. That means that it will not have
a high systematic risk. The volatility will, therefore, be due to unsystematic
factors that can be diversified away. That, in turn, suggests that the investment
may require a very low return.
This question is asked in various guises quite frequently. This was not
answered very well. Candidates should study systematic and unsystematic
risk and how the theories could be applied in different cases.
(iii) In theory the share price will rise by the NPV per share from the investment.
Accepting positive NPV projects creates wealth for the shareholders and that
should be reflected in the share price as soon as the markets become aware of
the investment.
In practice, there is no guarantee that the company will release sufficient

information for the market to make this evaluation. There is a commercial cost
to releasing information and Porter will not wish to alert competitors any
sooner than necessary.
There is also the question of whether the shareholders will agree with the
board’s evaluation of this project. The degree of optimism that should be
shown is really a matter of opinion.
Page 8
The shareholders may view any information of this nature as biased and self-
serving. The directors may not be honest in terms of disclosing the risks and
costs.
This question was poorly answered with few candidates making a

connection between share prices and accepting positive NPV projects.
(iv) Company directors are in a rather different position from shareholders. A

shareholder can hold a diversified portfolio of investments and can, therefore,
reduce the risks associated with a particular investment. A director will
probably have only one principal employer and will, therefore, be motivated
more by total risk.
This different perspective might be evidenced by a tendency to invest in

relatively safe projects. This is because a disaster might be rather catastrophic
for the board even though it would have relatively little impact on the
shareholders.
If the board proceeds with this investment then there is also a risk that the
shareholders will blame the directors for any failure in the project. Their
reputations may be at stake even though the risks are known and are being
taken in a considered manner.
This part was done very poorly with few candidates making any good points.
Page 9
EXAMINATION
3 October 2011 (am)

Core Technical
booklet.
supervisor.
question paper.
CT2 S2011 © Institute and Faculty of Actuaries

correct.
1 In certain circumstances a stock exchange may grant a quotation for a company even
though the company is not making any new shares or existing shares available to the
market. This method of obtaining a quotation is known as:
A a placing.
B a prospectus issue.
C a tender issue.
D an introduction.
[2]
2 Hold plc has 20 million shares outstanding priced at £5 a share. A rights issue will
allow one share to be purchased for every five shares currently held by shareholders
for £3 each. Which of the following is true?
A The number of shares outstanding will fall to 16 million.

B The firm will raise £32 million.
C The stock price will fall to £4.67.
D The company’s total value will decrease to £88 million.
[2]
3 Which of the following is NOT a characteristic of Eurobonds?
A They are relatively free from the controls of sovereign government.

B They are traded in an international over-the-counter market.
C They have tax deducted at source.
D They are bearer bonds and are generally unsecured.
[2]
4 Which of the following best describes the effects of an increase in the risk
characteristics of a project when evaluating its net present value?
A The discount rate increases and the net present value increases.
B The discount rate increases and the net present value decreases.
C The discount rate remains constant, but the net present value decreases.
D The discount rate decreases and the net present value decreases.
[2]
5 Which of the following long term liabilities would normally carry the highest rate of
interest?
A Fixed charge debenture

B Floating charge debenture
C Long term lease
D Unsecured bank loan
[2]
CT2 S2011—2
6 If a company has the phrase ‘Public Limited Company’ or the abbreviation ‘plc’ after
its name you know:
A that the company must be large.

B that the company must be quoted on a stock exchange.
C that the company must have an established track record.
D none of the above.
[2]
7 The payback method of evaluating a project can lead to the wrong decision being
made because:
A it ignores income beyond the payback period.

B the payback period is difficult to calculate.
C the returns in later years are uncertain.
D of the emphasis placed on the interest factor.
[2]
8 A building was purchased for £500,000 and has been depreciated by £20,000. It has
recently been revalued at £700,000. What will be the balance on the revaluation
reserve?
A £180,000
B £200,000
C £220,000
D £700,000
[2]
9 A company purchased some inventory towards the end of the financial year which
remained unsold at the year end. Which of the following statements describes the
manner in which this will be reflected in the financial statements?
A An expense in the income statement and a cash outflow in the cash flow
statement.
B An expense in the income statement and no effect on the cash flow statement.
C No effect on the income statement and a cash outflow in the cash flow
statement.
D No effect on either the income statement or the cash flow statement.

[2]

10 Which of the following best explains why a declining share price is thought to impose
some discipline on weak directors?
A The value of the directors’ share options will decline.

B The shareholders will withdraw their cash from the company.
C The cost of capital will be depressed.
D The company will be vulnerable to a takeover.
[2]
11 Trade credit and debt factoring are both used to provide businesses with short term
finance.
Describe the main features of each. [5]
12 Describe the costs and benefits associated with seeking a stock exchange quotation.
[5]
13 A company requires finance in order to expand.
Explain how the company’s tax position may affect the decision to use debt rather
than equity. [5]
14 Describe the role of the International Accounting Standards Board (IASB) in the
regulation of financial reporting. [5]
15 (a) Explain what is meant by the term “associate company”.
(b) Explain how associates are treated on consolidation. [5]
16 Discuss the reasons for requiring quoted companies to publish their diluted earnings
per share (EPS) in addition to their basic EPS. [5]
17 Explain why it may not be appropriate for management to choose the least expensive
source when raising fresh finance. [5]
18 Describe the process by which a holding company will construct a set of consolidated
financial statements. [5]
CT2 S2011—4
19 Digg is a manufacturing company that is considering the development of a new
product. The company has a factory building that is nearing the end of its useful life
and that is presently unoccupied. The directors are considering a project that would
put the factory to use for the remainder of its life.
Digg is considering the launch of a new product that could be manufactured in the
factory space. The following cash flows have been predicted for this project:
Investment in machinery £2.0m

Demand in first year 500,000 units
Demand in each of years 2–5 1,500,000 units
Selling price per unit £20.00
Materials cost per unit £8.00
Additional labour £800,000 per year
The investment in machinery will occur at the beginning of year 1. All other cash
flows will occur at the end of the year in question.
These figures reflect the “most likely” outcome demand for this product. There is a
70% probability that the product will generate this degree of demand.
There is a 30% “least likely” probability that demand will be 200,000 units in the first
year. In that case the project will be abandoned.
The labour will be provided by a specialist subcontractor who will require an

unbreakable five year contract.
The machinery purchased for this project will be disposed of for a negligible amount
that will barely cover the costs of its dismantling and removal.
The product requires a specialised alloy that is difficult and expensive to obtain
because it creates toxic by-products. Digg could buy a furnace that would enable it to
manufacture the alloy in-house. The furnace would have a five year life and could be
located in the factory that will be used for this project. Buying the furnace will reduce
the cost of materials by £5.00 per unit. The furnace itself will cost £1.2m, but it will
have to be decommissioned on disposal by a specialised recycling company once it
has been exposed to the by-products and this will cost a further £1.5m.
(i) Calculate the net present value of the project, using a discount rate of 9%, on
each of the following bases:
(a) Digg does not invest in the furnace and the “most likely” demand is
achieved.
(b) Digg invests in the furnace and the “most likely” demand is achieved.
(c) Digg does not invest in the furnace and the “least likely” demand is
achieved.
(d) Digg invests in the furnace and the “least likely” demand is achieved.
[8]

(ii) Calculate, using your answer to (i) above, the expected net present value of the
project both assuming that the furnace is not purchased and that it is. [2]
(iii) Comment on the usefulness of the expected value information produced in (ii)
above. [4]
(iv) Discuss the difficulties faced by the directors in this case in deciding whether
or not to proceed with this project or to invest in the furnace on the basis of the
net present value criterion. [6]
[Total 20]
CT2 S2011—6
20 Nation is a company that provides training and consultancy services to small and
medium-sized businesses. The company operates through a number of subsidiary
companies, each of which is relatively autonomous. Each subsidiary has a designated
part of the country in which to operate and the subsidiaries do not compete directly
with one another.
The directors of Nation are keen to ensure that each subsidiary maximises its
potential. To that end, they have decided to compare the performance of two
subsidiaries, North and South. The latest annual reports produced by these companies
are as follows:
Income statements
for the year ended 31 July 2011
North South
£000 £000
Revenue 1,600 2,900
Cost of sales 640 1,015
Gross profit 960 1,885
Advertising and distribution 240 522
Administration 128 116
Operating profit 592 1,247
Interest 24 11
Net profit 568 1,236
Statements of financial position

as at 31 July 2011
North South
£000 £000
Property, plant and equipment 2,000 2,300
Current assets
Receivables 160 455
Total assets 2,160 2,755
Equity 1,400 2,515
Loans 450 200
Current liabilities
Overdraft 310 40
Total equity and liabilities 2,160 2,755

(i) Compare the performance of the two divisions in terms of their profitability,
liquidity and management of receivables. Your answer should be supported
by relevant ratios. [14]
(ii) Describe the limitations of your analysis in (i), explaining why the directors
should seek additional information before making changes to the operation of
either subsidiary. [6]
[Total 20]
END OF PAPER
CT2 S2011—8
EXAMINERS’ REPORT

Core Technical
Purpose of Examiners’ Reports
The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and who are using
past papers as a revision aid, and also those who have previously failed the subject. The
Examiners are charged by Council with examining the published syllabus. Although
Examiners have access to the Core Reading, which is designed to interpret the syllabus, the
Examiners are not required to examine the content of Core Reading. Notwithstanding that,
the questions set, and the following comments, will generally be based on Core Reading.
For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report. Other valid approaches are always given appropriate credit; where there is a
commonly used alternative approach, this is also noted in the report. For essay-style
questions, and particularly the open-ended questions in the later subjects, this report contains
all the points for which the Examiners awarded marks. This is much more than a model
solution – it would be impossible to write down all the points in the report in the time allowed
for the question.
T J Birse
December 2011

Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, September 2011
General comments on Subject CT2
This paper examines basic finance including raising funds by a variety of methods, taxation,
net present value and project appraisal and other topics, it has both calculations and essay
type questions on these topics. The paper also examines financial reporting including
preparation of the main financial statements and interpretation of financial statements it also
considers the basis of the preparation of statements and the information needs of a variety of
end users of financial statements.
Different numerical answers may be obtained to those shown in these solutions depending on
whether figures obtained from tables or from calculators are used in the calculations but
candidates are not penalised for this. However, candidates may be penalised where excessive
rounding has been used or where insufficient working is shown.
Comments on the September 2011 paper
The general performance was slightly better than in April 2011 well-prepared candidates
scored well across the whole paper. As in previous diets, overseas candidates did not perform
quite so well as UK candidates. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Candidates approaching the
subject for the first time are advised to concentrate their revision in these areas.
Page 2
1 D
2 C
3 C
4 B
5 D
6 D
7 A
8 C
9 C
10 D
Workings for question 2:

A – one on every five shares cancelled
B – 4m shares issued at £5 + 3 = £8 each
C – theoretical ex rights price for 6 shares = (£5 × 5) + £3 = £28 = £4.67/share 9
D – market capitalisation = £100m, less 4m shares issued at £3 = £88m
Workings for question 8:

A – 700 – (500 + 20)
B – 700 – 500
C – 700 – (500 – 20) 9
D - 700
The multiple choice questions were done very well by most candidates. No question caused
any more problem than another.
11 Trade credit is advanced by suppliers, who permit payment to take place sometime
after the delivery of the goods . This is a relatively simple arrangement that is easy to
obtain if the customer has a reasonable credit history . There is no interest as such,
although the purchase price will include something for the cost of credit. If excessive
time is taken to pay for goods then the credit facility may be withdrawn .
Debt factoring is effectively a means of borrowing against the company’s trade
receivables. The factor may assume the risk of bad debt. There is an explicit interest
charge for this finance.
This question was answered well by most candidates.
Page 3
12 There will be the usual issuing costs if the quotation takes the form of an offer for
sale. There will also be costs in terms of accountability, with the need to meet the
stock exchange’s disclosure requirements.
Being quoted will make it easier to issue new shares because the shares will be more
readily marketable. The existing shareholders will benefit from the ability to liquidate
their investment. The quotation will also enable the shareholders to value their stakes
very easily because there will be a recognisable market price.
13 Interest on debt can be claimed as an expense for tax purposes. That will make the
cost of debt much cheaper than equity. The tax saving will only materialise if the
company is making taxable profits. Profit should be forecast into the foreseeable
future to establish whether the anticipated profits will be large enough to enable the
tax savings to be utilised. If there will be insufficient profit then the cost of interest
should be evaluated gross. There will always be a risk associated with borrowing and
so the decision should not be based on cost alone, regardless of the tax savings.
This question was done poorly by some candidates. The main point which was not discussed
was the tax effect on the cost of debt.
14 The IASB develops IFRSs . These standards form the starting point when reviewing
the accounting policies applied by a company. If a company does not comply with
IFRS then the auditor is likely to qualify the audit report. Shareholders and other
stakeholders will also expect the statements to be prepared in accordance with IFRS.
IFRS have been instrumental in reducing differences between companies and in

making financial statements more comparable. That has been a significant
improvement in terms of establishing the credibility of the regulation of accounting.
This question was answered well by many candidates. Most candidates knew that the
financial statements had to be prepared using rules in the standards. Few candidates
mentioned the auditor
15 An associate is subject to significant influence from the holding company. Influence

is normally obtained when the holding company has a significant stake, but not
sufficient to grant control. Owning 20% or more, but less that 50%, will normally
create this relationship.
The fact that the holding company can merely exert influence means that it would not
be appropriate to include the value of its assets in the consolidated financial
statements. Instead, the holding company’s share of the associate’s results are
included in the consolidated income statement — regardless of whether it actually
receives these by way of dividend. The consolidated statement of financial position
Page 4
includes the holding company’s share of the associate’s assets and liabilities, but as a
single line item in the accounts.
This question was not done particularly well. Some candidates made a very poor attempt at
this. It just had to be learned from the manual so it was surprisingly badly done.
16 The need for diluted EPS arises because the basic EPS calculation ignores the impact
of “potential” shares. Companies can issue warrants, options, convertible securities
and so on, all of which give their holders the right to obtain shares on preferential
terms. If those rights are exercised, the EPS enjoyed by the existing shareholders will
be diluted because the equity introduced will not be sufficient to compensate for the
larger number of shares ranking for a dividend.
The EPS ratio is an important ratio used to measure and discuss the company’s
profitability. It is the basis for the Price/Earnings ratio which is used to determine the
company’s strength. Any distortion of the EPS ratio will confuse the discussion of
P/E.
There were some excellent answers to this question which was very heartening.
17 The least expensive form of finance is likely to be the one that offers the lowest risk
to the provider. Risk cannot be eliminated, but it can be passed from one party to
another and the less risk taken by the provider the greater the risk being taken by the
borrower. For example, bank loans are likely to give the lender significant rights in
the event of default. That protects the lender, but means that the borrower faces
closure in the event that a vital asset has to be surrendered in the event that the lender
exercises those rights.
The fact that equity passes the risk to the investor explains why it is more expensive
than debt. The company need not pay shareholders a dividend unless it can afford to.
This question was not done very well at all. Few candidates could say why debt was cheaper
than equity and most did not relate this to risk. Risk is an important consideration when
considering the financing decision and this plays a major part in the cost of debt and equity.
Page 5
18 The members of the group have to be identified. The holding company has to ensure
that all entities that are controlled are included in the group accounts as subsidiaries.
Consolidation involves cancelling all internal balances between group members. Any
such balances will have to be identified so that they can be eliminated against one
another. One effect of that is that goodwill on consolidation will have to be
recognised and accounted for in order to ensure that the statement of financial
position still balances after eliminating investments against the corresponding equity .
The balance invested by the non-controlling interest will have to be determined and
accounted for too.
This question was done well by most candidates.
19 (i)
Most likely demand

Without furnace
Year 0 cash flows = (2,000,000) NPV = (2,000,000)
Year 1 cash flows = Sales 10,000,000 NPV = 5,200,000 × 0.917 = 4,768,400
Material (4,000,000)
Labour (800,000)
Total 5,200,000
Years 2–5 cash flows = Sales 30,000,000 NPV = 17,200,000 × (3.889 − 0.917) = 51,118,400
Material (12,000,000)
Labour (800,000)
Total 17,200,000
Total 53,886,800
With furnace – incremental cash flows

Year 1 cash flows = Material 2,500,000 NPV = 2,500,000 × 0.917 = 2,292,500
Years 2–5 cash flows = Material 7,500,000 NPV = 7,500,000 × (3.889 − 0.917) = 22,290,000
Year 5 cash flow = (1,500,000) NPV = (1,500,000) × 0.650 = (975,000)
Incremental saving 22,407,500
Total 76,294,300
Least likely demand

Without furnace
Year 1 cash flows = Sales 4,000,000 NPV = 1,600,000 × 0.917 = 1,467,200
Material (1,600,000)
Labour (800,000)
Total 1,600,000
Years 2–5 cash flows = Labour (800,000) NPV = (800,000) × (3.889 − 0.917) = (2,377,600)
Total (2,910,400)
Page 6
With furnace – incremental cash flows

Year 1 cash flows = Material 1,000,000 NPV = (500,000) × 0.917 = (458,500)
Decommissioning (1,500,000)
Total (500,000)
Incremental outflow (1,658,500)
Total (4,568,900)
This part was not done well by candidates. Many made careless mistakes and lost some
marks.
(ii) The expected value if the furnace is not purchased is

(53,886,800 × 70%) + (− 2,910,400 × 30%) = £36,847,640.
The expected value if it is purchased is

(76,294,300 × 70%) + (-4,568,900 × 30%) = £52,035,340
Candidates did well in this part and their own figure was used in this part so
they were not penalised twice for a mistake in part i.
(iii) The expected value information provides very little useful information in this
case because it does not reflect the returns that will actually be enjoyed.
In each case, there is a 70% chance of a positive NPV and a 30% chance of a
smaller, but still significant, negative NPV. In that context, the value of the
potential cash flows may bear little or no real relationship to their weighted
average. Risk averse individuals may decide that a 30% chance of losing
£2.9m or £4.6m is a good reason to abandon the project, even though there is a
corresponding chance of a much higher gain.
Very few candidates could explain expected value or understood what the figures meant. This
was disappointing.
(iv) The directors cannot really consult the shareholders over decisions such as this
ad so it is difficult to develop a clear understanding of the shareholders’
preferences. There will always be some risk associated with an investment and
so the directors will find it difficult to avoid risks if they are to generate any
meaningful return. Abandoning projects because they have a downside will
always lead to a lost opportunity.
The directors face the problem that the company will release only limited
information about the project and so the shareholders may not fully appreciate
the benefits that it will generate for them. The board could be criticised
unfairly for proceeding with a sound decision.
Page 7
The outcome of the project will be evaluated with the benefit of hindsight. The
shareholders may find it difficult to see beyond the fact that the most likely
demand did not materialise if the project fails and they lose money as a result.
The directors may be deterred from investing in projects that have a significant
downside because of that.
This part was done poorly by candidates. The candidates generally do not do so well when
asked to demonstrate understanding of the results.
20 (i)
North South
Profitability
Return on capital 592/(1,400 + 450) = 32% 1,247/(2,515 + 200) =
employed 46%
Gross profit percent 960/1,600 = 60% 1,885/2,900 = 65%
Advertising/revenue 240/1,600 = 15% 522/2,900 = 18%
Liquidity
Current ratio 160/310 = 0.5:1 455/40 = 11.3:1
Efficiency
Receivables turnover 160/1,600 × 365= 37 455/2,900 × 365 = 57
days days
Both companies have strong return on capital employed, but South is much
stronger than North. The margins are higher and so North may be
concentrating on more lucrative work. It may be that South is getting a better
return on its advertising because it is spending more and that might be
necessary in order to get a return. South also appears to be more efficient
because it is generating a much higher turnover from only a slightly higher
asset base.
North has a large overdraft relative to current assets, which is a major worry.
If the overdraft is called in then North could be rendered insolvent. South has
no such problems
North has a much shorter receivables turnover. That may explain its lack of
success in generating new business. If the company presses for prompt
payment then customers may be tempted to go elsewhere. It may be that the
cash is being chased because of the burden of servicing the large overdraft.
This part was done reasonably well by candidates. Many did the calculations well but did not
explain their results very clearly.
(ii) The directors should consider whether the figures are directly comparable. The
accounting policies should be the same in both companies, but the underlying
assumptions may be different. For example, South may be a little more
aggressive when it comes to booking turnover.
Page 8
The nature of the local markets may also be different. It may be that North is
already doing as well as is possible, subject to the local conditions. Changes
may actually be harmful.
South is much bigger in terms of turnover and that might create economies of
scope that are not available to North. For example, South may be able to
employ a wider range of consultants.
This part was reasonable.
Page 9
EXAMINATION
26 April 2012 (am)
Subject CT2 – Finance and Financial Reporting

Core Technical
booklet.
supervisor.
question paper.

correct.
1 Why should an eligible bill of exchange be regarded as a very secure investment?
A The issuer is eligible to issue secure bills of exchange.

B The holder of the bill is eligible to claim repayment in full at any time.
C The bill has been guaranteed by a bank.
D The bill has been drafted by an eligible intermediary.
[2]
2 What aspect of a limited liability partnership (LLP) is “limited”?
A The liability of individual members is limited to £100,000.
B The liability of individual members is limited to their agreed share of the

partnership’s liabilities.
C No member can suffer loss due to the acts or omissions of another member.
D The LLP’s creditors cannot normally seek payment from the members
themselves.
[2]
3 A quoted company made a substantial rights issue. A shareholder who had a

substantial shareholding did not wish to take up the right to buy shares and forgot to
sell those rights.
Which of the following best describes the effects of this forgetful shareholder’s
actions?
A The forgetful shareholder was worse off because of the rights issue and the
other shareholders were unaffected.
B The forgetful shareholder was worse off because of the rights issue and the
other shareholders were better off.
C The forgetful shareholder was unaffected by the rights issue and the other
shareholders were better off.
D The forgetful shareholder was unaffected by the rights issue and the other
shareholders were worse off.
[2]
CT2 A2012–2
4 Which of the following best supports the assertion that the payment of a dividend
signals confidence on the part of the directors?
A The dividend is paid out of past profits that have actually been earned.
B The directors are keen to receive dividends from their own shareholdings.
C The directors have to find the cash with which to pay the dividend.
D The shareholders will react badly to the non-payment of a dividend.
[2]
5 The net present value criterion is generally claimed to provide the most consistent and
relevant basis for the selection of investment projects.
Which of the following situations creates the greatest threat to the validity of
evaluating projects using net present value in practice?
A Net present value ignores risk.
B Shareholders may disagree with the results of a net present value calculation.
C The calculation of net present value can lead to two solutions.
D Managers may wish to undertake the project for selfish reasons and could
manipulate the analysis.
[2]
6 A company’s external auditor included an emphasis of matter in the audit report.
Which of the following statements best describes the meaning of an emphasis of

matter?
A The auditor wishes to draw attention to an important matter that has been
disclosed in the notes to the financial statements.
B The auditor wishes to draw attention to the limitations of the work undertaken
during the audit.
C The audit report is being qualified.
D The auditor disagrees with the information in the financial statements.

[2]
CT2 A2012–3 PLEASE TURN OVER

7 Which of the following is most likely to arise as a consequence of the money
measurement concept?
A Assets will be recorded at cost.

B Some valuable assets will be excluded from the financial statements
altogether.
C Expenses will be accrued regardless of when the associated payment is made.
D Assets will not be written down to their break-up values.
[2]
8 Which of the following statements relating to current assets is correct?
A Current assets will be realised within one year.
B Current assets have short expected useful lives.
C Current assets comprise cash and items that will be converted into cash in the
normal course of business.
D Current assets always comprise inventories, receivables, bank and cash.

[2]
9 Which of the following best explains why investment analysts often calculate
Earnings before Interest, Taxation, Depreciation and Amortisation (EBITDA)?
A EBITDA is less prone to fluctuations and volatility than net profit.

B Depreciation and amortisation are not real costs to the business.
C Investment analysts are only interested in performance before tax.
D EBITDA is regarded as less prone to manipulation than net profit.
[2]
CT2 A2012–4
10 Net asset value per share is calculated by subtracting intangible assets from ordinary
shareholders’ equity and dividing the remainder by the number of shares in issue.
Which of the following best explains the relevance of net asset value per share?
A In the event that the entity is wound up the chances are that its intangible
assets will not have any market value, but the shareholders will be certain to
receive the value of the remaining net assets after disposal.
B In the event that the entity is wound up the net asset value per share is likely to
represent the best possible outcome that the shareholders can expect.
C The shareholders should monitor the net asset value per share and should insist
that the entity be wound up in the event that net asset value per share exceeds
the market value of the company’s shares.
D Net asset value per share is likely to correspond to the value that an unquoted
company’s shares would have on the open market.
[2]
11 Explain why, from a tax perspective, many individual shareholders prefer to earn a
return from an increase in the share price rather than payment of a dividend. [5]
12 Martha is seeking funding for a company that she wishes to establish. Her plans
involve too much risk for a conventional bank loan but a venture capital company has
offered to invest in convertible loan stock.
Discuss the disadvantages to Martha of funding her company by issuing convertible

loan stock to a third party. [5]
13 Outline the uses to which currency futures can be put. [5]
14 Four engineers have established a company to manufacture a new product that they
have patented. Each of the directors owns 25% of the company’s equity. They have
employed a qualified accountant to manage the company’s record-keeping and to
engage with potential lenders on the company’s behalf.
Describe the respective legal responsibilities of both the company’s directors and its
accountant in relation to record-keeping and lenders. [5]
15 Explain how a lessee can take on the risks and rewards of ownership of an asset, even
though the leased asset remains the property of the lessor. [5]

16 Explain how there could be a conflict between the interests of directors and
shareholders over the raising of additional finance, where the directors would prefer
the company to issue equity and the shareholders would prefer the company to
borrow. [5]
17 Explain why accounting information that is relevant may not be reliable and why
accounting information that is reliable may not be relevant. [5]
18 Discuss the usefulness and limitations of a company’s annual report to the company’s
lenders. [5]
CT2 A2012–6
19 Barton manufactures animal feed using machinery that is both very simple and very
robust. The company has operated independently since it was founded.
Barton’s primary product cannot be manufactured using modern technology and

Barton faces very little competition within its market niche. The product is popular
with horseracing stables and other horse owners who wish to promote the health and
stamina of their animals.
Barton’s owner is planning to retire and has offered to sell the company to Nufeed, an
animal feed business that manufactures animal feed using heavily industrialised
processes. Nufeed is interested in acquiring Barton because it will complement its
existing product range and will demonstrate Nufeed’s commitment to manufacturing
traditional products using traditional methods.
Barton’s owner proposes that the company’s selling price should be set by
multiplying the most recent profit figure by a multiple that has yet to be agreed.
Nufeed’s chief financial officer is reviewing Barton’s financial statements in order to
establish whether that is a realistic suggestion.
Barton’s property, plant and equipment figures are as follows:
Plant and
Property equipment Total
£000 £000 £000
Cost
As at 31 March 2011 800 250 1,050
Additions 50 9 59
As at 31 March 2012 850 259 1,109
Aggregate depreciation
As at 31 March 2011 272 170 442
Charge for year 16 10 26
As at 31 March 2012 288 180 468
Net book value

As at 31 March 2012 562 79 641
As at 31 March 2011 528 80 608
All of Barton’s property, plant and equipment is shown at cost less depreciation.
Property is depreciated at a rate of 2% of cost every year and plant and equipment at a
rate of 4% of cost.
Property comprises a large factory building located in the countryside, close to several
large farms that provide the company’s raw materials.
Plant and equipment comprises heavy milling and mixing equipment that was built to
Barton’s specifications when the company was established. The equipment is
maintained to a very high standard by Barton’s head of production, who has worked
for the company for almost 20 years.

Nufeed commissioned a report on the plant and equipment. The report stated that it
would cost at least £1.2 million to replace the production machinery. With the correct
maintenance, this type of equipment can have a very long useful life, but very few
engineers have the skills to repair ongoing wear and tear. In the absence of such a
skilled maintenance team, the bearings would wear out after approximately ten years,
resulting in the scrapping of the equipment.
The equipment has almost no resale value because it is too large and heavy to be
dismantled and removed.
Nufeed’s chief financial officer has asked Barton’s owner to restate the depreciation
charge to deal with the effects of inflation. Barton’s owner has refused on the basis
that it could be argued that depreciation ought to be zero because the plant and
equipment has no market value. Furthermore, he has not asked Nufeed to pay
anything for Barton’s good name and loyal customer base because neither of those
assets is recognised in the company’s statement of financial position (balance sheet).
(i) Explain why it appears that Barton’s depreciation charge may have been
understated. [5]
(ii) Calculate an alternative more relevant depreciation charge for Barton’s plant
and equipment that would better reflect the use of these resources. [3]
(iii) Explain the logic underlying your depreciation calculation. [3]
(iv) Outline the logic behind Barton’s owner’s claim that the depreciation charge
should be zero. [3]
(v) Discuss the validity of the claim made by Barton’s owner that he has not
charged Nufeed anything for the company’s reputation and customer base. [6]
[Total 20]
CT2 A2012–8
20 Manor is a quoted property company that specialises in the development and resale of
commercial office buildings. The company frequently invests in large projects that
run for between three and five years, with that being the typical timescale from the
acquisition of a new property to its resale after redevelopment.
Manor evaluates potential investments using the net present value (NPV) criterion.
The NPVs of all proposals are calculated using a discount rate of 8% p.a. The
criterion has been in place for at least the past ten years. The finance director is
unhappy that the company’s principal investment criterion has been in place for so
long that none of the present senior executives were in post when it was introduced.
As a result, nobody knows the reasons for its selection. That has become an issue in
recent years because the property market has been depressed and most of the
investment opportunities have offered a negative NPV when discounted at 8% p.a.
The shareholders are beginning to become anxious that the company is not putting its
assets to good use because the proceeds of selling developed properties are being
banked instead of being reinvested in fresh projects.
The chief executive has asked the finance director to consider the following
possibilities:
• Calculate the NPV using a discount rate of 5% p.a., at least until the property
market improves and creates the possibility of higher returns.
• Continue to discount investment opportunities at 8% p.a., but take a more

optimistic view of future cash flows from projects under consideration. Most
projects have a range of possible outcomes and many become desirable when
evaluated using the “best possible” outcome for costs and revenues rather than the
“most likely”.
(i) Discuss the validity of Manor’s policy of using an 8% p.a. discount rate when
calculating the NPV of investment opportunities. [8]
(ii) Discuss the logic behind reducing the discount rate for evaluating projects to
5% p.a. until the property market improves. Your discussion should cover
both the validity of the proposed reduction in the discount rate and the likely
impact on Manor’s share price. [8]
(iii) Discuss the validity of evaluating projects using the “best possible” forecast
outcomes instead of the “most likely”. [4]
[Total 20]
END OF PAPER
CT2 A2012–9
EXAMINERS’ REPORT

Core Technical
Introduction
candidates, both those who are sitting the examination for the first time and who are using
past papers as a revision aid, and also those who have previously failed the subject. The
Examiners are charged by Council with examining the published syllabus. Although
Examiners have access to the Core Reading, which is designed to interpret the syllabus, the
Examiners are not required to examine the content of Core Reading. Notwithstanding that,
the questions set, and the following comments, will generally be based on Core Reading.
this report. Other valid approaches are always given appropriate credit; where there is a
commonly used alternative approach, this is also noted in the report. For essay-style
questions, and particularly the open-ended questions in the later subjects, this report contains
all the points for which the Examiners awarded marks. This is much more than a model
solution – it would be impossible to write down all the points in the report in the time allowed
for the question.
T J Birse
July 2012

Subject CT2 (Finance and Financial Reporting) – April 2012 – Examiners’ Report
Comments on the April 2012 paper
Although, the general performance was slightly poorer than in September 2012, well-
prepared candidates scored well across the whole paper. As in previous diets, overseas
candidates did not perform quite so well as UK candidates. The comments that follow the
questions concentrate on areas where candidates could have improved their performance.
Candidates approaching the subject for the first time are advised to concentrate their revision
in these areas. The main questions that caused candidates difficulty were Q19 and 20.
Page 2
1 C
2 D
3 B
4 C
5 D
6 A
7 B
8 C
9 D
10 B
The MCQs were done well.
11 Most individual shareholders pay income tax at their highest marginal rate when they
receive any dividend income. They have very little opportunity to manage that
liability and so tax will almost certainly become payable whenever a dividend is
received.
If the company retains earnings then, in theory, the share price will rise. Shareholders
are not taxed on that gain unless they realise it by selling their shares. That gives the
shareholders an opportunity to plan their pattern of taxable gains in any given year
because they can time the realisation by delaying the sale of their shares if they so
wish.
In addition, individual shareholders receive an annual allowance that can reduce the
amount paid on gains beneath the allowance to zero. Furthermore, the tax rate on
capital gains is generally lower than that which would be suffered on income.
This question was done well by candidates with most having good knowledge of the tax
system.
12 The advantages to the lender generally cause equivalent disadvantages to the

borrower. Martha will have to find the cash to pay interest on the bonds during the
debt phase of the instrument. While that interest may be payable at a lower rate than
would be paid on an outright loan, it is still a commitment that the new business will
have to make.
In the event that Martha’s business succeeds, the chances are that the bondholder will
convert the bond to shares. That will dilute her equity and will reduce her return from
having taken the initiative to start this business and work to make it a success. Thus,
the bond will impose all of the downside risks associate with borrowing when the
business is at its most vulnerable and will reduce the upside risks associated with any
success that the business enjoys.
Page 3
This question was not done well by candidates In general points written down were too few
and at too high a level.
13 Currency futures can be used to manage risk exposures. The most logical use for a
future would be to manage downside risk on a future receipt or payment of foreign
currency. For example, if a company had made a sale to a foreign customer and had
been forced to invoice in the customer’s currency there could be a risk that the rates
will move adversely during the period before settlement. A currency future could be
entered into so that the sum due is sold for delivery at a future date, thereby
guaranteeing the company’s future receipt. The only significant cost would be the
interest foregone on the margin deposit that would have to be made.
Futures can also be used to create a substantial exposure for speculative purposes. An
investor who predicted a significant shift in a particular currency that appears to have
been mispriced could enter into a futures contract in order to obtain a more significant
position than could be possible using cash reserves to buy and hold the currency itself.
This question was done badly my many candidates. Many answers were extremely brief and
had very little detail.
Candidates had very little knowledge of this area. Many knew what futures were, but did not
know much more and were unsure what they were for.
14 The directors are ultimately responsible for the company’s administration and any
relationships that it develops with third parties. They cannot make somebody else
responsible for those matters even if their expertise in engineering means that they are
not particularly well equipped in business or financial management. They can, of
course, delegate the actual work of maintaining books or talking to banks to a
financial manager if they so wish.
The company’s accountant will be required to fulfil the duties that are spelled out in
the contract of employment. Those duties may have to be discharged in accordance
with standards imposed by the accountant’s professional body. The directors will bear
the ultimate legal responsibility for ensuring that the company is compliant with all
relevant legislation, but the directors will be entitled to expect that the work will be
completed to a very high standard of quality.
This question was answered reasonably well.
15 The lessee may sign a lease that grants the right to use the asset for a specified period
that amounts to virtually the whole of the asset’s anticipated useful life. Provided the
lessee makes the agreed lease payments the lessor will have little or no rights over the
asset. Thus, the lessee can make full use of the asset for most or all of its useful life
and thereby enjoys the full rewards of ownership.
Such lease arrangements are unlikely to be cancellable because the lessor will
normally acquire the asset to meet the lessee’s specifications. The lease payments will
Page 4
continue even if the asset becomes obsolete or redundant because the lessee’s needs
change. The lessee will almost certainly have to agree to accept responsibility for any
loss or damage to the asset while it is in the lessee’s custody. Thus, the lessee will
effectively have to pay for the cost of the asset plus interest (via the lease payments)
and suffer all the risks of ownership in the process.
This question was answered well by most candidates.
16 The shareholders prefer the entity to borrow, within reason, because debt is cheaper
than equity. The shareholders enjoy the benefit of the wealth created from the lenders’
investment and they also enjoy the benefits of the tax shield on borrowing. The risks
associated with borrowing are borne directly by the company and so the shareholders
will not have to risk their personal assets in the event that the company fails.
The directors are more directly exposed to the risks of gearing. If the company fails
because it cannot meet its loan commitments then the directors will face the loss of
their jobs. If they issue further shares then the shareholders will be unlikely to ever
have an incentive to put the company into receivership because they will lose
everything that they have invested.
17 Relevant information is generally future-oriented. Users find information relevant if it

informs decisions that have to be made and that will typically involve a comparison of
the outcomes the different decisions will have. For example, the decision as to
whether an asset should be retained or sold requires an understanding of the future
cash flows that it will generate and also of the amount that it will realise on the open
market.
Information is reliable if it can be checked easily and measured against an objective

benchmark. Generally, reliable information is historical and may not necessarily have
much predictive value. For example, the historical cost of an asset is a very reliable
measure because it can be verified against its associated invoice.
This question was done reasonably well the part on reliable information was poorer than the
section on relevant information.
18 The financial statements are prepared by the directors and audited with a view to
informing the shareholders. The figures in the financial statements may be designed to
report past profitability, whereas the lenders would prefer a conservative evaluation of
the present position to inform decisions about collectability. The information in the
financial statements is largely historical, whereas lenders are primarily interested in
future cash flows to ensure that they are capable of servicing a loan commitment. The
statement of financial position will list the company’s debts and the assets that are
available to settle them and so that gives an insight into security, but the asset values
Page 5
are not necessarily guaranteed in the event of a failure and associated disposal under
conditions of duress.
There is also a problem in that the annual report is not sufficiently frequent for the
lender to monitor the security of an advance.
This question was not done very well by candidates. The answers were usually too short and
general. Many candidates only wrote two sentences. This was not enough to pass the
question, as the allocation of marks available indicates.
19 (i) Depreciation is effectively the recognition of the fact that an entity consumes
resources in the form of property, plant and equipment when manufacturing
goods. Barton’s depreciation charge is based on a percentage of the historical
cost of the assets being used. Barton’s assets are very old and so those
historical costs have become virtually meaningless. The resulting depreciation
figure is perfectly consistent with accounting regulations, but it is not
necessarily representative of the costs being incurred when reporting to
decision makers. Any comparable business would have to report a much
higher depreciation charge because it could not acquire assets for the same
price as Barton. The property is stated at historical cost and therefore the
depreciation charge is likely to be lower than if it was charged on current
values.
This question was done very poorly with a surprising number of candidates having little idea
what depreciation is.
(ii) Notional cost of assets = £1.2m

Notional useful life = 10 years
Charge = £1.2m/10 = £120,000 per annum
This question was straightforward but was generally not answered correctly.
(iii) This charge is calculated on the basis that the replacement cost of the assets is
more relevant than their historical cost. The resulting depreciation recognises
the economic cost of the wear and tear.
The useful life is based on the argument that ten years is realistic when the
company does not employ a craftsman such as Barton’s head of production.
Even if Barton has such an employee in post, there is no guarantee of retaining
that person indefinitely and so the artificially long lives of the assets will be
curtailed.
This question was also not done well. Candidates had difficulty with the idea that having a
craftsman as head of production could affect the useful life.
Page 6
(iv) The negotiation of the selling price of a business is complicated by the fact
that accounting regulations do not necessarily lend themselves to every
situation. Barton’s machinery has been fully depreciated on a historical cost
valuation and the fair value of the assets is normally determined by looking at
their market valuation, which is also zero. Thus, Barton’s owner can claim that
depreciation on production machinery is zero and such a claim is consistent
with accounting regulations. If the owner insists on making the best possible
use of this loophole then profit may be overstated and that could be used as an
argument to inflate the selling price for the business.
This question was answered incorrectly by many candidates who felt that the market value
was relevant to the depreciation calculation.
(v) The proposal involves basing the selling price on a multiple of profit. That
automatically incorporates the effects of the factors that the owner has
mentioned. The company’s good name and customer base will have
contributed to past profits and so they are included in the valuation of the
company as a going concern. The fact that they are not being priced separately
does not mean that they are being excluded altogether.
It could be argued that the good name will become less valuable if Barton is
taken over and becomes associated with a large and modern company. Part of
the reason for company’s success in this niche is the fact that it is a small
company manufacturing in a traditional way.
This part of the question was poorly answered with some candidates just missing it out.
20 (i) This criterion takes some account of the time value of money. It also requires
all investments to achieve positive NPV using a discount rate that has,
presumably, been arrived at through trial and error or on some other basis.
Perhaps the standard discount rate of 8% p.a. will not reflect the risks of any
particular project, but the alternative would be to invest significant time and
effort in determining a more realistic target for each investment and there is no
guarantee that the resulting figures will be any more suitable. All investment
decisions require subjective decisions about the risks and returns.
The fact that Manor is investing in property means that it is fairly unlikely that
it will be faced with a massive risk of loss on a project, even if it is necessary
to hold an investment until a market blip sorts itself out. Also, the fact that the
projects have a typical life of three to five years means that using a different
discount rate would have very little impact on the overall net present value.
More stringent criteria would be justified in the case of a different industry
with longer project lives, but the impact in this case would not be material.
This part was not done very well by candidates. They generally did not mention the scenario
set out in the question at all but just discussed NPV in general terms.
Page 7
(ii) There is no justification for reducing the discount rate just to make more
projects appear to be profitable. It would make just as much sense to abandon
project appraisal altogether and simply accept all projects on some random
basis.
If the market is declining then that might suggest that it is riskier and a higher
discount rate than 8% p.a. should be used.
If the shareholders discover that the company is seeking only a modest return
on its investments then the share price will decline. Logically, the shareholders
will evaluate projects using their own evaluation of risk and return and the
share price will decline if the company accepts projects that have a negative
NPV when evaluated in the shareholders’ terms.
Clearly, the shareholders will not necessarily be aware of investments unless

the directors inform them. Even if the fact that an investment is being made is
disclosed, the directors will not publish their forecasts on NPV calculations.
If the directors do make a series of poor investments because of this strategy

then the shareholders will only become aware of that when the results of those
investments start to appear in the published accounts. It may take at least two
or three years before a series of weak returns starts to impact on reported
ROCE.
This part was done badly by almost all candidates. Candidates did not mention shareholders
and did not discuss the discount rates in any detail. Where candidates discussed this in part
(i) credit was given.
(iii) The most obvious risk is that any evaluation based on “best possible” is
unlikely to achieve the anticipated results and is likely to be a disappointment.
The shareholders will almost certainly wish the directors to evaluate any
projects on the basis of the outcomes that are likely to be achieved and they
may regard the use of will lead to the acceptance of best possible as a
dishonest attempt to justify unsuitable investments.
It could be worth considering the best possible outcome as one aspect of

decision-making. Risky projects often have an upside potential as well as a
downside and so the possibility that an upside may be enjoyed is worth
considering as one factor in choosing between competing projects.
This part of the question was done better than parts (i) and (ii).
Page 8
EXAMINATION
5 October 2012 (am)

Core Technical
booklet.
supervisor.
question paper.

correct.
1 Grove is a quoted company that has a dividend yield of 7%. The present share price
is £1.40. Grove’s directors have announced a one for ten scrip issue and they have
made it clear that the dividend per share will not be reduced as a result of the issue.
What is the expected value of the shares under these circumstances?
A £1.27
B £1.36
C £1.40
D £1.54
[2]
2 An investor holds a broad portfolio of investments. Which of the following is a

systematic risk which may affect the value of her portfolio?
A One of the companies in her portfolio has changed the basis on which it
prepares its financial statements, thus lowering reported profits.
B Legislation changes, resulting in one company losing sales and going into
receivership.
C Interest rates could rise.
D A new product launched by one of the companies in her portfolio is deemed to

be a commercial failure.
[2]
3 A company manufactures car engines and buys in a large number of components from
other companies. The company has a choice between two investment projects. It can
build a small factory that will manufacture the most expensive components that it
currently buys in from third parties. The savings on those components will be very
substantial. Alternatively, it can build a large factory that will manufacture all of the
components that it currently buys in. There will be a saving on all components
manufactured, but the amount saved on the less expensive items will be much smaller.
Each investment is equally risky. Which of the following is the most likely when the
internal rate of return and net present value from the two projects are compared?
A The small factory option has a higher IRR than the large factory option, and a
higher NPV.
B The small factory option has a higher IRR than the large factory option, and a
lower NPV.
C The small factory option has a lower IRR than the large factory option, and a
higher NPV.
D The small factory option has a lower IRR than the large factory option, and a
lower NPV.
[2]
CT2 S2012–2
4 Which of the following best describes the reason for a company that has secured debt
issuing subordinated debt?
A The cost of subordinated debt will be lower than the secured debt.
B The issue will not affect the rights of existing debt holders.
C There are fewer formalities associated with the issue of subordinated debt than
secured debt.
D The issue of subordinated debt will be viewed as a sign of confidence by the

markets.
[2]
5 Which of the following accounting concepts is breached when a company recognises

a gain in the market value of its property?
A money measurement
B going concern
C cost concept
D business entity
[2]
6 An actuary started a consultancy in 2005 by investing his life savings of £40,000 in

the business and borrowing £20,000 from a bank. Since then, the consultancy has
grown to the point where it owns an office worth £100,000 and equipment worth
£7,000. Trade receivables in the form of work that has been invoiced but not yet paid
for total £8,000. The business now has bank loans totalling £82,000 and owes £500
for unpaid bills. What is the value of the actuary’s equity?
A £25,000
B £32,500
C £40,000
D £52,500
[2]
7 Which of the following best describes the statement of changes in equity?
A a summary of revenues and expenses for the period

B a summary of the assets, liabilities and equity as at the end of the period
C a summary of changes in capital and reserves attributable to the equity holders
D a summary of movements in cash and cash equivalents for the period
[2]
CT2 S2012–3 PLEASE TURN OVER

8 A company had cash sales of £60 million and credit sales of £150 million during its
most recent financial year. The company had trade receivables of £40 million and
£5 million of sundry receivables for rental income and similar balances at the year
end.
How long is the trade receivables turnover period?
A 70 days
B 78 days
C 97 days
D 110 days
[2]
9 Which of the following best summarises the relevance of the income (interest) cover
ratio?
A provides shareholders with an important insight into the risks associated with
their investment, but is relatively unimportant to lenders
B provides no useful information to either shareholders or lenders
C provides lenders with an insight into the short-term risks associated with their
loans, but is relatively unimportant to shareholders
D provides lenders with an insight into the short-term risks associated with their
loans and is important to shareholders
[2]
10 Which of the following does NOT explain why historical cost accounting overstates
profit during times of inflation?
A The bookkeeping system records historical costs and ignores changes in

values.
B The cost of sales figure ignores the increasing replacement cost of inventory.
C Interest is valued at nominal rates rather than real rates.
D Depreciation charges do not reflect increasing replacement costs.

[2]
11 Two actuaries are considering establishing a consultancy business and are considering
incorporating as a limited company. The company will have to borrow in order to
raise sufficient finance to get started. The actuaries would have to pledge personal
guarantees before a bank will grant a loan to their company.
Discuss the benefits of incorporating as a limited company in these circumstances.

[5]
CT2 S2012–4
12 Discuss the implications of the threat of a takeover for the behaviour of a quoted
company’s directors. [5]
13 An investment fund has been established to track the performance of a standard stock
market index. The fund manager will construct a portfolio of investments that will
perform as closely as possible to the index.
Discuss the advantages of investing in such a fund. [5]
14 Describe the implications for companies if it is not clear whether a significant expense
is permissible for tax purposes. [5]
15 A corporate borrower has a loan with fixed rate interest repayments.
Explain why the borrower might wish to arrange an interest rate swap.
[5]
16 Explain why quoted companies have to use rights issues when they wish to issue
additional shares in order to raise equity.
[5]
17 Discuss the potential benefits and drawbacks to be obtained from simulation in the
evaluation of an investment project. [5]
18 Explain the difficulties faced by the International Accounting Standards Board

(IASB) in setting credible accounting standards. [5]

19 Dayton is a manufacturing company that is planning to expand by acquiring a
business that operates in a complementary area. Dayton has identified two potential
acquisitions, Echo and Foxton, that both appear to be suitable for consideration.
Dayton will acquire only one company.
The following financial indicators have been gathered in order to assist with the
decision:
Dayton Echo Foxton
Revenue £500m £250m £140m

Return on capital employed 18% 14% 11%
Profit margin 26% 22% 33%
Gearing 52% 44% 28%
Price/Earnings ratio 12.3 16.2 14.1
(i) Discuss the impact that the acquisition of each entity would have on Dayton’s
financial indicators. [10]
(ii) Discuss the suitability of a typical set of published financial statements for the
purpose of deciding a price for a controlling interest in a target company. [6]
A subsequent analysis of the two potential target companies indicates that the
purchase of Echo will lead to the recognition of a much larger amount for
goodwill on consolidation than the purchase of Foxton.
(iii) Explain the significance of this difference between the goodwill figures. [4]
[Total 20]
20 Hatton is a quoted company in the entertainment industry. The company’s directors

are extremely ambitious and strive to maximise Hatton’s rate of growth. The
directors have identified the availability of finance as the company’s biggest
constraint.
The directors have been offered the opportunity to invest in two projects, each
involving the development of a new games console. The projects involve competing
products and so they are effectively mutually exclusive because there would be no
commercial justification in investing in both.
Project A requires an investment of £20 million and has a projected net present value
of £80 million. Project B requires an investment of £50 million and has a projected
net present value of £200 million. Hatton does not have any spare cash and so it will
have to raise finance in order to invest in either project.
The directors of Hatton are unable to decide which of the two investments is better for
the company. Each is relatively risky, but the two projects are exposed to virtually
the same factors that will determine success or failure and, in that sense, the risks are
virtually identical.
CT2 S2012–6
Hatton is heavily geared. The company’s equity has a book value of £900 million and
its debt has a book value of £350 million. Hatton made a large share issue last year
and the directors do not believe that they could seek further equity in the short term.
The company’s debt includes a major loan from a commercial bank that carries a debt
covenant under which the loan is repayable in the event that gearing (measured as
debt as a percentage of total finance) exceeds 30%.
Hatton’s marketing director is keen to proceed with Project B on the basis that it
offers the greatest opportunity to enhance the company’s share price.
Hatton’s chief executive is keen to proceed with Project A on the basis that it will be
possible to finance that project without taking the company to the very brink of its
debt covenant.
Hatton’s finance director has urged caution and recommends refusing both
opportunities on the grounds that the only cost of doing so is the opportunity cost.
His reasons for this recommendation is that the company is already heavily involved
in the games business and it might be better to diversify into other areas of
entertainment. In his opinion, refusing the projects will not risk harm to Hatton’s
share price.
(i) Outline the reasons why a bank might impose a debt covenant such as that
affecting Hatton’s borrowing capacity. [6]
(ii) Discuss the risks associated with Hatton permitting its borrowings to rise to
the maximum gearing level agreed with its bank. [6]
(iii) Discuss the validity of comments made by the finance director that:
(a) the share price will not be harmed by the opportunity cost associated
with turning down an investment project with a positive NPV.
(b) the share price could be improved by Hatton diversifying its

investment base. [8]
[Total 20]
END OF PAPER
CT2 S2012–7
EXAMINERS’ REPORT

Core Technical
Introduction
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.
The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.
D C Bowie
December 2012

Subject CT2 (Finance and Financial Reporting) – September 2012 – Examiners’ Report
The general performance was slightly poorer than in April 2012 although well-prepared
candidates scored well across the whole paper. The comments that follow the questions
concentrate on areas where candidates could have improved their performance. The main
problems were Q14 and 20.
Page 2
1 C
2 C
3 B
4 B
5 C
6 B
7 C
8 C
9 A
10 C
Workings
1 A 1.40 × 10/11
B (1.40 × 10/11) + 7%
C present share price – unchanged because the return on each share is expected
to remain constant
D 1.40 + 10%
6 Equity = Assets – liabilities
A £25,000 = (100,000 + 7,000) – (82,000) − Ignore WC
B £32,500 = (100,000 + 7,000 + 8,000) – (82,000 + 500) – correct answer
C £40,000 = initial stake
D £52,500 = (100,000 + 7,000 + 8,000) – (82,000 + 500 – 20,000) – ignore initial

loan
8 A 40/(150 + 60) × 365 = 70 days – total sales

B (40 + 5)/(150 + 60) x 365 = 78 days – total sales and sundry debtors
C 40/150 × 365 = 97 days – correct answer
D (40 + 5)/150 × 365 = 110 days – includes sundry debtors
The MCQs were done well as usual.
Page 3
11 The company will offer greater flexibility in the future. Admitting fresh capital will
require only the sale of shares to one or more new principals. The company will
probably be easier to sell in the future because there will be greater clarity over its
assets and liabilities. There will be fewer matters that have to be agreed or decided at
the early stages of the business’ existence because the company will have to be
incorporated and managed in accordance with the requirements of company law. The
company will have to prepare its accounts in accordance with specific accounting
standards and that will give the company a more credible track record when dealing
with third parties. The partners’ personal liability will be restricted to the guaranteed
loan, so the other creditors will not be able to seek compensation from their personal
assets.
12 The directors will be aware that any inefficiency could lead to the shares becoming
devalued. In that case it will have the effect of encouraging a third party to make an
offer to buy a controlling interest. Such bids usually involve the payment of a
premium over the market price and so they will only make commercial sense if the
direction of the company is changed and refocused in the aftermath of the takeover.
That usually means replacing the management team and so the existing directors will
be made redundant. If the takeover is contested then there is likely to be a public
argument about the company’s ineffective management and so the directors’
reputation will be damaged and they will be less marketable in terms of their careers.
On the other hand, the directors have a responsibility to act in the interests of the
company’s current shareholders, and if the existing shareholders were going to take
cash then any overvaluation is in their interest and they should not be concerned about
the future direction of the company.
This question was done badly by some candidates with very few candidates mentioned
replacing the management team or ensuring the management team was effective.
13 The most obvious advantage is that management costs will be substantially reduced
compared to a more proactive fund. The fund’s managers do not need to conduct
extensive research because they are actively trying to “buy the market” and so there is
no need to spend time and incur cost in identifying “good” investments. That will also
mean that there are likely to be fewer agency issues because the fund’s managers do not
need to deliver performance that exceeds the market rate. If the index has a weak return
then the fund will mirror that, but the managers will still have performed in accordance
with expectations. Dealing costs will also be reduced because the only transactions that
will be necessary will be the very occasional purchase or sale to refocus the balance of
the fund if it starts to fall out of line with the index that it is tracking. Such funds will
also be attractive to investors who wish to diversify in a particular direction that is
served by a fund, into such investments as Singaporean securities or whatever.
Investing in this fund will offer investors a degree of diversification, which may be
less risky for those investors who would otherwise buy a narrow range of securities.
Page 4
14 The uncertainty will create a distraction for management because they will have to
agree an interpretation with the tax authorities. That will increase legal and
accountancy fees because the directors have a duty to resolve any disagreement in the
company’s favour. This could prove expensive because the tax authorities have the
backing of government and are likely to afford to spend more in the pursuit of an
increased tax payment than the company can spend in defence. The tax authorities
could be motivated by the desire to establish a precedent and that could mean the case
gets blown out of all proportion.
The uncertainty will make it far more difficult for the company to budget and plan its
cash flows. There is also a risk that the company will base major decisions on
assumptions about tax planning that could prove to be invalid if the tax authorities
press for a different interpretation.
This question was done very badly which was disappointing.

Many candidates did not answer what was asked in the question but discussed tax in
general.
15 It is possible that management will have a change of heart in the course of an

extensive loan period. For example, a fixed rate loan could have been taken out at a
time when it was felt that interest rates were likely to rise, but that threat could have
passed. Switching to a variable rate loan could prove cheaper. Swaps provide a far
cheaper alternative to facing the penalties associated with early repayment and the
replacement of one loan with another.
Some entities have a specific advantage in a particular area of finance. For example,
banks often raise funds at variable rates by taking customer deposits. It is attractive to
diversify by mixing fixed rate with variable rate liabilities. Banks can offer a variable
rate loan via a swap arrangement at a rate that would be more attractive to many
borrowers than a straightforward variable rate loan arranged in the traditional way.
16 Issuing fresh shares can undermine the interests of existing shareholders. For
example, the shares will normally have to be issued at a discount and that will dilute
the existing shareholders’ investments. Also, the directors could place shares in such a
way as to interfere with the ability of particular groups to exercise control.
Rights issues mean that there can be no dilution effect because the shareholders can
either buy the shares and take advantage of the discounted price or they can
compensate themselves by selling the rights. There is also no question of passing
control to a particular group by placing shares with them or of excluding a powerful
group of shareholders from a placement. Existing shareholders can continue to hold
their present proportion of the company provided they can afford to take up their
rights.
The stock exchange rules or the company’s articles may require the use of rights
issues.
Page 5
17 Simulation copes with the mathematical problems associated with more traditional
modelling of investment decisions. Provided the probability distributions are
reasonably realistic then there is no need to solve all of the equations that are implied
by a more traditional model. Computing power is cheap and readily available and so
the simulation can be run as frequently as necessary to be confident that the results are
robust. The output is relatively easy to understand because the results can be
expressed in terms of the probabilities of achieving a result that is better or worse than
a given target.
The advantages must be discussed in terms of the potential drawbacks. The fact that
there is no mathematical solution means that the results could be very misleading if the
model is incorrectly specified. Such errors may not come to light until it is too late.
The technique is reliant on the quality of inputs and assumptions and by increasing the
number of assumptions about probability distributions or project outcomes, you
increase the risk that some of them are invalid.
This question was answered reasonably well; some candidates did not discuss that the
results could perhaps be misleading.
18 One problem is that businesses are complex entities and their accounting issues are
often difficult to understand. The interests of shareholders and other users are also
complex and it is difficult to know exactly what information is required, especially
given the possibility that shareholders have access to information from sources other
than the annual report.
The fact that the standard setting process is international means that standard setters
have to cope with cultural problems in terms of different business practices. Even the
translation of standards into other languages will affect the standard setter’s task.
Historically, standards have been set in response to problems with accounting and that
has made the standard-setting process reactive. Preparers of financial statements can
also interfere with the standard setter’s ability to enforce unpopular standards.
This question was answered reasonably well by many candidates. Many candidates gave good
answers that included good discussion of international standards and the problems associated
with translation.
Page 6
19 (i) Foxton is considerably smaller than Echo in terms of revenue and would not
impact Dayton’s revenue to the same extent. Echo has the higher return on
capital employed of the two alternatives, but both are lower than Dayton.
Dayton will take a reduction on ROCE in either case, but it is not necessarily
clear which of the two will have the greater impact when size is taken into
account. The following could be used to estimate the impact:
Dayton Echo Foxton

Profit = profit margin × revenue £130m £55m £46m
Capital employed = profit/ROCE £722m £393m £418m
Revenue £500m £250m £140m
Dayton’s revised ROCE when combined 17% 15%
Foxton has a higher profit margin and so it will enhance Dayton’s margin
when the two businesses are combined. Dayton will appear to be a better
trader when combining the figures
Both Echo and Foxton have lower gearing ratios than Dayton. Unfortunately,
both will be forced to cancel preacquisition equity if they are consolidated and
so both will simply add liabilities to Dayton’s statement of financial position.
Thus, in the short term, Dayton’s gearing will increase even further. In the
longer term, Foxton can generate £140m × 33% = £46.2m of profit every year
and Echo £250m × 22% = £55m and so both will start to accrue retained
earnings for the group, thereby diminishing gearing.
The P/E ratios suggest that Echo will be the more expensive acquisition
because the markets presently value the company at a higher multiple of
earnings and the company is also larger to begin with. It may be that Foxton
will be the better investment because the same industrial and commercial logic
applies to each company and so Dayton can build its entry into that niche just
as easily from Foxton as from Echo.
(ii) The financial statements are not designed for this purpose. The accounts are
prepared to assist the shareholders with stewardship decisions concerning the
actions of the directors and are not intended to stand alone as the basis for an
investment decision. For example, the information in the financial statements
is historical whereas valuation is always forward-looking. Also published
accounts value assets on the basis of going concern and ignore some
adjustments that a buyer would insist upon. For example, the valuation of
inventories and receivables may be relatively rough and may overlook
overstated figures that would concern a buyer.
There is also the possibility that the preparers of financial statements have
taken advantage of the flexibility in accounting to push the reporting earnings
in a desired direction. The directors may wish the shares to change hands at the
highest possible price and profit could be influenced so as to bring that about.
Page 7
(iii) Goodwill is the difference between identifiable net assets and the price paid.
That suggests that Echo’s likely selling price will be affected to a greater
extent by unrecognised intangibles such as brand names and human assets.
That goodwill will drive down the ROCE in the consolidated financial
statements. It will also leave the group exposed to a greater threat of
impairment adjustments because there is more goodwill to be impaired.
Generally all parts of this question were answered reasonably well. Part (iii) was the poorest
with candidates not demonstrating much knowledge of intangible assets. Candidates were
unsure of the effect on ROCE.
20 (i) Banks impose restrictive covenants on further borrowing because they do not
wish to risk their principal being left unpaid if the company is forced into
liquidation. If a company fails then lenders are paid out of its assets before the
shareholders receive anything. Limiting the proportion of assets financed by
borrowing should ensure that here are sufficient assets to pay all creditors in
full. If there are not then many lenders will be forced to settle for just a
percentage of the amount that is owed to them.
Lenders will also wish to restrict total borrowings because high gearing
increases the risk that a company will fail because of the need to raise cash in
order to service debt. Even if the company has sufficient funds to pay lenders,
there will be costs (e.g. legal expenses) if the loan defaults. It will also leave
lenders with cash that they have no immediate use for and so it will cost them
interest if they are repaid early and without much advance
warning.
Limiting gearing might also make the shareholders more risk averse. If the
company has been financed largely from borrowings then the shareholders
might feel rather reckless because much more of the risk is being borne by
lenders. Making the shareholders commit a significant amount of their own
money to the venture means that the business should be managed more
responsibly.
(ii) Allowing borrowings to come close to the maximum means that the
company’s finances will be less flexible and less responsive in the face of new
opportunities. It can be difficult to raise equity quickly and it is often
uneconomical to raise equity in relatively small amounts. Loans can be raised
relatively quickly and for comparatively short periods. This makes it desirable
for a company to have some borrowing capacity free.
If the gearing ratio is close to the maximum then any losses might reduce
equity and that could create problems with meeting loan conditions. Similarly,
downward revaluations of fixed assets could reduce equity and increase
gearing to unacceptable levels.
Banks might be reluctant to continue short-term overdraft facilities if the

company is viewed as highly geared. They might decide to reduce the
Page 8
overdraft limit at a time when the gearing ratio would make it difficult to raise
fresh debt from other sources.
There is always a risk that new accounting standards will be introduced that
will have the effect of reducing the book value of equity or increasing the
book value of debt. The closer the company is to its borrowing limits, the
greater the risk that any new standard will cause problems.
(iii) (a) The capital markets will not be aware of the decision to turn down a
positive NPV project and so the assertion may be true in the short term.
The problem that arises is when the company passes on so many
opportunities that reported earnings start to decline. Ongoing
investments are generally necessary in order to maintain a competitive
edge and keep the company on track to meet investor expectations.
Investors will also start to benchmark the company against similar
businesses and will see the effects of the competitors’ investments in
terms of revenues and profits. This is clearly going to be a significant
issue in an industry such as entertainment where companies are
constantly announcing new products and fresh directions.
(b) This ignores the fact that the shareholders can diversify for themselves.
The CAPM suggests that shareholders evaluate risk on the basis of
diversified portfolios and the specific risks associated with, say,
specific industry characteristics, disappear because of diversification.
The shareholders are more likely to be confused by an investment that
takes Hatton away from the core business that the board clearly
understands. Diversification by the company will create inefficiencies
that are likely to reduce the share price. On the other hand,
diversification within the company may help avoid the costs of
possible financial distress and so be of value to the shareholders.
This question was done badly. Part (iii) was poor especially part (b). Part (i) was not too bad
and part (ii) was poorer. Generally candidates understood that high gearing was risky and
why but in part (ii) they did not do well.
In part (iii)(b) candidates generally could not answer this question and did not discuss
diversification.
Page 9
EXAMINATION
18 April 2013 (pm)

Core Technical
booklet.
supervisor.
question paper.

correct.
1 Which of the following best describes the possibility of an agency relationship

between company directors and debenture holders?
A There is no agency relationship because the debenture holders are protected by

the terms of their debenture.
B The directors could indulge in risky behaviour that threatens the value of the
debenture holders’ stake in the company.
C The debenture holders do not appoint the directors and so the directors are not
the debenture holders’ agents.
D The debenture holders bear exactly the same agency risks as the shareholders.
[2]
2 Which of the following statements is most likely to be true of an investment trust?
A The trust’s shares are likely to be at a discount to the value of the trust’s
underlying assets because many trusts’ investment strategies are
misunderstood.
B The trust’s shares are likely to equal the value of the underlying assets because
the capital markets will not misprice the assets held by the trust.
C The trust’s shares are likely to be at a premium to the value of the trust’s
underlying assets because the trust managers are skilled in managing
investments.
D The trust’s shares are likely to be at a discount to the value of the trust’s
underlying assets because of the net present value of the trust’s management
charges.
[2]
3 Which of the following best explains the logic behind attaching a warrant to a bond
issue?
A Issuing warrants will enable the company to repay the bonds from the
associated share issue.
B The lender may be prepared to accept a lower rate of interest in return for the
capital appreciation offered by the warrant.
C Warrants motivate the shareholders by offering the opportunity to spread the

risks associated with investment.
D In an ideal world, the warrants will expire before they can be exercised.
[2]
CT2 A2013–2
4 Which of the following best describes the cost of providing finance from retained
earnings?
A There is no cost associated with retained earnings.

B Retained earnings are less expensive than equity share capital.
C Retained earnings are equally expensive as equity share capital.
D Retained earnings are more expensive than equity share capital.
[2]
5 Which of the following justifies the use of the payback method for evaluating capital
investment projects?
A Management has to predict cash flows from the project in order to determine
payback.
B Projects with short payback are always more profitable.
C Projects with short payback always have higher net present values.
D Projects with short payback are always more predictable.

[2]
6 A company is preparing its financial statements and must decide on an accounting

policy for an unusual situation that is not covered by accounting standards. Which of
the following best explains how the company should proceed?
A The company can use any policy that it wishes.
B The company should use the policy that ensures the smallest profit.
C The company should use the policy that yields the strongest statement of
financial position.
D The company should apply the logic in any accounting standard that deals
with broadly comparable circumstances, even though that standard is not
directly applicable.
[2]
7 Which of the following best summarises the dual aspect concept?
A There are frequently two or more ways to approach any accounting judgement.
B Every transaction affects two balances and both must be adjusted in the
bookkeeping records.
C There ought to be independent verification of matters of judgement.
D The bookkeeping records ought to be backed up regularly and the backup copy
kept securely.
[2]

8 Which of the following best describes the process of preparing consolidated financial
statements for a group comprising a parent and an 80% subsidiary?
A Cancel all relationships between the group members and add the figures for
assets and liabilities together.
B Cancel all relationships between the group members and add 80% of the
subsidiary’s assets and liabilities to the parent’s.
C Cancel 80% of all relationships between the group members and add the
remaining figures for assets and liabilities together.
D Cancel 20% of all relationships between the group members and add the
remaining figures for assets and liabilities together.
[2]
9 Which of the following best explains why companies must publish their diluted
earnings per share?
A Diluted earnings per share takes account of the board’s intentions to issue
fresh equity.
B Undiluted earnings per share is irrelevant for decision making purposes.
C The undiluted earnings per share figure can be misleading when an equity
issue has occurred during the year.
D Existing equity holdings can be diluted by the right to purchase fresh equity at
a preferential rate.
[2]
10 A manufacturing company has consistently used historical cost accounting since its
incorporation. Which of the following best describes the implications of basing the
return on capital employed ratio (return) on historical cost figures?
A Both return and capital employed are likely to be understated.
B Both return and capital employed are likely to be overstated.
C Return is likely to be understated and capital employed is likely to be

overstated.
D Return is likely to be overstated and capital employed is likely to be

understated.
[2]
11 Explain whether a loss-making company should allow for the effects of tax when
deciding whether to raise fresh finance through debt or equity. [5]
CT2 A2013–4
12 Sarah recently inherited a substantial sum of money. Her friend Tom is a successful
businessman who owns a small factory. Tom is a sole trader. He has offered Sarah
the opportunity to become a sleeping partner in his business. She will invest
£200,000 of her inheritance in return for a partnership share of 30% of all future
profits. She will not take any part in the running of the business. The business is
profitable and is struggling to keep up with demand, so the expansion will probably
be successful.
Describe the risks that Sarah will be taking on if she enters into this arrangement with
Tom. [5]
13 A company’s directors are considering issuing redeemable preference shares as an

alternative to borrowing. They believe that the company is too close to its borrowing
capacity and so equity is preferable to debt.
Outline the implications for the company of issuing redeemable preference shares in
these circumstances. [5]
14 Explain why finance leases have to be accounted for on the basis that the asset and an
associated liability must appear in the lessee’s statement of financial position, even
though the lessee does not own the asset. [5]
15 A company’s treasurer has negotiated an interest rate swap to exchange cash flows on
the company’s fixed interest loans with the counterparty’s cash flows on a floating
rate loan.
Discuss the risks to the company associated with the swap arrangement. [5]
16 An energy generation company is considering building a wind farm instead of a more

traditional power station. This would be the company’s first investment in this
technology.
Discuss how simulation could be useful in the evaluation of the investment in the
wind farm. [5]
17 The directors of a quoted company are discussing a proposal from an investment bank
that would enable the company to exploit a legal loophole, allowing it to borrow
funds without the commitment affecting the company’s gearing ratio.
Discuss the implications of this proposal for the company’s shareholders. [5]
18 A small company has a policy of obtaining the latest annual report from each of its
customers and calculating liquidity ratios for credit control purposes.
Discuss the usefulness of a typical company’s annual report for this purpose. [5]

19 You have been asked to assist Holder, a manufacturing company, to prepare its annual
accounts. The following information has been obtained from the company’s
bookkeeping records:
Balances as at 31 March 2013

£000
Administrative salaries 3,600
Advertising 66,000
Bank overdraft 1,650
Buildings – depreciation 45,000
Buildings – valuation 450,000
Cost of inventory consumed 435,000
Delivery vehicle running costs 51,000
Delivery vehicles – cost 375,000
Delivery vehicles – depreciation 255,000
Dividend paid 150,000
Factory running costs 105,000
Interest 38,400
Inventory at 31 March 2013 36,000
Land – valuation 840,000
Loan (repayable 2018) 300,000
Machinery – cost 186,000
Machinery – depreciation 84,000
Manufacturing wages 195,000
Revaluation reserve 240,000
Revenue 1,686,000
Sales salaries 84,000
The figures shown above do not include the following:
1. A revaluation exercise was conducted on 1 April 2012. Land was revalued at
£1,000,000,000 and buildings at £500,000,000.
2. Depreciation has still to be charged as follows:
• Buildings – 2% of cost or valuation
• Delivery vehicles – 25% reducing balance
• Machinery – 20% of cost
Prepare:
(a) an income statement
(b) a statement of changes in equity, and
(c) a statement of financial position
for the year ended 31 March 2013.
These statements should be in a form suitable for publication insofar as it is
possible from the information provided. [20]
CT2 A2013–6
20 Partan is a quoted company. The directors have asked for a report on the company’s
cost of capital. The following information has been provided:
• The market capitalisation of the company’s equity is £600 million.
• The company has debentures with a face value of £250 million. Their market
value is £220 million.
• The corporation tax rate is 23%.
• The risk–free rate of interest is 4% per annum.
• The ungeared beta on Partan’s equity is 1.3.
• The debentures have a coupon rate of 5% and are redeemable at par in five years’
time.
• The market rate of return is 9% p.a.
The directors have already calculated Partan’s weighted average cost of capital
(WACC), but they wish you to prepare a calculation in order to confirm their figures.
They are concerned that the WACC is higher than they think is justified and they wish
to discuss some proposals for reducing the figure because the directors plan to raise
further finance in order to fund expansion, but they are unwilling to do so if the cost
of capital is overstated.
(i) Determine Partan’s cost of equity using the company’s geared beta. [4]
(ii) Determine Partan’s approximate cost of debt. [4]
(iii) Calculate Partan’s WACC. [2]
The marketing director has suggested that the company could dramatically reduce the
cost of capital if the board promotes the company in the same way that it promotes its
products. The directors should identify the market’s needs and explain to those who
provide finance just how well suited Partan is to meeting those needs.
(iv) Discuss the logic of the marketing director’s proposal for reducing the WACC.
[10]
[Total 20]
END OF PAPER
CT2 A2013–7
EXAMINERS’ REPORT

Core Technical
Introduction
The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.
D C Bowie
July 2013

Comments on the April 2013 paper
The general performance was slightly improved than in September 2012 well-prepared
candidates scored well across the whole paper. The comments that follow the questions
concentrate on areas where candidates could have improved their performance. Candidates
approaching the subject for the first time are advised to include revision of these areas in their
preparation. The main problems were Q19 and 20; however many candidates scored
excellent marks in all questions.
Page 2
1 B
2 D
3 B
4 C
5 A
6 D
7 B
8 A
9 D
10 D
None of the multiple choice questions caused problems and the marks were good for
questions 1–10.
11 Companies should take the effect of tax into account when determining the cost of
finance. Most companies will find that debt reduces taxable profit, which will also
reduce the cost of debt compared to equity. If the company is making losses then the
use of debt will simply increase the loss for tax purposes and so there will be no tax
benefit.
It may be that losses can be carried forward and offset against future taxable profits,
so that should be considered as part of the overall analysis.
Perceptions could also be important. If the directors act in a manner that suggests
they do not see a return to profit in the foreseeable future then the shareholders may
view that as a lack of confidence.
The tax effects of certain borrowing schemes can be relevant even to loss making
companies. For example, lessors can often claim the tax benefits associated with
buying assets into account in setting lease payments. Those can be passed on to
the borrower in the form of a lower lease payment.
The answers to this question were weaker than for many others. Many candidates did not
seem to know much about taxation and why it might be considered in financing decisions.
12 The first risk is that Sarah could lose everything. As a partner she will not be
reimbursed her capital in the event of failure unless all of the creditors have been paid
in full.
If the business makes a loss then her capital will be eroded.
In the event that she finds Tom difficult to work with she will have to either persuade
him to buy her stake or she will have to have his agreement to sell her stake to a third
party. In any case, it may be difficult to find an interested potential buyer.
Page 3
Sarah’s liability will be joint and several. She will be liable for all of the debts
incurred by the business, not just the 30% implied by her stake. Creditors could
pursue her personal property in the event that they are left unpaid.
There were some excellent answers to this question.
13 From a financial point of view, the issue of redeemable preference shares may be very
similar to issuing debt. The directors will be able to suspend the preference dividend
in the event that they could not afford to pay it so there is a little more flexibility than
borrowing. However, there will be a penalty, almost certainly involving the
suspension of the ordinary dividend while the preference dividend remains unpaid.
The rate of preference dividend is fixed, which means that the impact on the volatility
of earnings per share is equivalent to making fixed interest payments. In some ways,
preference shares may be worse because the preference shareholder will want a
significant rate of dividend to account for the risk that is being taken relative to
lending.
The redemption of the share imposes exactly the same financial burden as a loan that
is to be repaid in a lump sum at the end of the loan period.
Candidates will be awarded marks if they write about the accounting treatment of
redeemable preference shares as set out in IAS 32.
Candidates were slightly weak at this question. There were few very good answers.
There seemed to be a general lack of understanding of this topic.
14 The definition of an asset hinges on the question of control. That can sometimes be
distinguished on the basis of holding the risks and rewards of ownership. The nature
of a finance lease is that the lessee enjoys the risks and rewards of ownership because
the lease grants the lessee the use of the asset for most or even all of the asset’s
expected useful life.
If the asset is recognised in the financial statements then it will be necessary to show
the associated liability arising from the lease. If the lessor has purchased the asset
for the lessee’s exclusive use then it follows that the lessee must be committed to
repaying the value of that asset through the lease payments.
Legal ownership is not a material element of the definitions of assets or liabilities.
This question was done very well by most candidates.
Page 4
15 The swap itself may lead to a negative net present value. Presumably, the company
signed the swap in the expectation that interest rates will fall, in which case, the swap
would effectively lower the cost of borrowing. If rates rise then the swap will cost the
company money.
The two parties do not actually exchange their commitments, so the failure by the
counterparty would not leave the company committed to both sets of payments.
The default of the counterparty could leave the company with an uncollectable
receivable if the cash flows were in the company’s favour.
The counterparty may be at risk in either scenario. If rates fall then the counterparty
may be at a commercial disadvantage to competitors with floating rate liabilities, who
can pass the reduction in interest rates on to customers in the form of lower prices. If
rates rise then the counterparty’s customers may reduce their spending in response.
This question had some very mixed answers; some candidates did very well and others lacked
understanding of swaps.
16 Simulation is an excellent way to deal with complicated projects where there are
many interactions between variables. The success or otherwise of this investment will
be affected by the economy and demand for power. Fuel prices will affect the cost of
conventional power generation and the ability of the competition to undercut wind
power. Those factors may affect costs such as interest (e.g. higher energy prices will
increase inflation and so boost interest rates).
Simulation will make it possible to model such links in a detailed manner and to run
the model frequently until an equilibrium is reached. This can be combined with
unrelated variables, such as the weather – which will again affect demand and also the
ability of wind power to generate electricity.
This question was done very well by most candidates. This question has been asked in a
slightly different format in previous diets and it was not surprising that it was done well.
17 In the worst possible case the directors will create the risks associated with borrowing
without any corresponding disclosures. That could lead to shares being purchased
and sold at inflated prices. It could also lead to shareholders accepting risks that they
would normally refuse.
The company could fail unexpectedly if it fails to keep up with the commitments
imposed by this arrangement.
The shareholders are likely to suffer greater borrowing costs than would arise from
traditional loans. The investment banks tend to charge a fee for their services in
providing this type of arrangement.
Many candidates did this question well.
Page 4 Page 5
18 The statement of financial position shows a snapshot of liquidity at a point in time.
The figures are determined annually at the same time of year. That may give an
insight into changes, but it also ignores the possibility that the year-end position is at
the very end of the annual business cycle and is not representative of the year as a
whole.
The liquidity position can be distorted by window-dressing and so it may understate

any liquidity risks.
The statements are not published immediately after the year end and so there could
have been a massive change in the liquidity picture since the year end. The company
could have looked solvent six weeks ago but that could mean very little with respect
to current trade payables.
This question was done extremely well.
19 (a)
Holder
Income statement
for the year ended 31 March 2013
£000
Revenue 1,686,000
Gross profit 903,800
Administration expenses (3,600)
669,200
Interest paid (38,400)
Profit for year 630,800
(b)
Holder
Statement of changes in equity
for the year ended 31 March 2013
Share Revaluation Retained Total

capital reserve earnings
£000 £000 £000
Opening balance 210,000 240,000 262,350 712,350

Revaluation 255,000 255,000
Profit for year 630,800 630,800
Dividends (150,000) (150,000)
Closing balance 210,000 495,000 743,150 1,448,150
Page 6
(c)
Holder
Statement of financial position
as at 31 March 2013
Notes £000
Non-current assets
Property, plant and equipment (1) 1,644,800
Current Assets
Inventory 36,000
162,000
Total assets 1,806,800
Equity and liabilities

Equity
Revaluation reserve 495,000
1,448,150
Non-current liability
Loan 300,000
Current liabilities
Bank 1,650
58,650
1,806,800
Page 7
Notes
(1) Property, plant and equipment
Cost or valuation Land Buildings Machinery Vehicles Total

£000 £000 £000 £000 £000
Opening balance 840,000 450,000 186,000 375,000 1,851,000

Revaluation 160,000 50,000 210,000
Closing balance 1,000,000 500,000 186,000 375,000 2,061,000
Depreciation
£000 £000 £000 £000 £000
Opening balance 45,000 84,000 255,000 384,000

Revaluation (45,000) (45,000)
Charge for year 10,000 37,200 30,000 77,200
10,000 121,200 285,000 416,200
Net book value 1,000,000 490,000 64,800 90,000 1,644,800
Workings
Cost of sales
cost of inventory consumed 435,000
factory running costs 105,000
manufacturing wages 195,000
depreciation of buildings 10,000
depreciation of machinery 37,200
782,200
Distribution
advertising 66,000
delivery vehicle running costs 51,000
sales salaries 84,000
depreciation of vehicles 30,000
231,000
Candidates generally demonstrated a good understanding of the basic issues of accounts

preparation. There were some excellent attempts at this question but also some very weak
attempts.
There are many places that errors can occur and it is very easy to make careless mistakes.
Page 8
20 (i) Geared beta = ungeared beta × (1 + debt:equity ratio × (1 − tax rate))

= 1.3 × (1 + 220/600 × (1 − 0.23))
= 1.667
ke = 4 + (1.667 × (9 − 4))
= 12.335
(ii) Coupon payment on debt = 250 × 5% = 12.5
NPV of debt at 6% = −220 + (12.5 × 4.212) + (250 × 0.747) = 19.4
NPV of debt at 10% = −220 + (12.5 × 3.791) + (250 × 0.621) = −17.36
Yield is approximately half way between 6% and 10% = 8% (to nearest

whole %)
kd = 8% × (1 – 0.23) = 6.16
(iii) WACC = (220/(220 + 600) × 6.16) + (600/(220 + 600) × 12.335) = 10.678%
(iv) It is very unlikely that the capital markets will be swayed by promotional
material that simply describes Partan in a positive way. Advertising can create
an emotional response to a product, but that is unlikely to be effective in the
development of a company’s financial instruments. Market participants will
be keen to see evidence that the company can generate a cash surplus and have
already formed a view on the extent to which that will happen. The
information that is already in the public domain will have been incorporated
into the share price and simply restating that information in the form of a sales
promotion is unlikely to change anything.
It is possible that the directors will have a more positive view on the
company’s prospects because they have inside knowledge and will be better
informed. It may be that they can communicate some of that additional
information in order to correct any under-pricing. If the markets believe the
directors then the cost of capital may be re-evaluated and reduced.
The fact that the directors have an incentive to argue for a lower cost of capital
may mean that the shareholders will be suspicious of this initiative. The
directors will almost certainly have to release commercially sensitive
information that is open to verification. The cost of capital may then decline
slowly when the initial disclosures are shown to be valid and the markets start
to trust the board. If the company develops a reputation for keeping the
markets informed in a timely and accurate manner then the directors will
develop a reputation for honesty and the cost of capital may remain at a lower
level.
This question was possibly the least well done question of the paper. Parts (i) and (iii) were
badly done with candidates making a variety of mistakes. The theory part of the question was
Page 9
done badly by a number of candidates, with some of the explanations given showing very
little understanding of the subject.
Page 10
EXAMINATION
26 September 2013 (pm)

Core Technical
booklet.
supervisor.
question paper.

correct.
1 An Australian trader is due to receive a substantial receipt in Euros in three months’

time. Which of the following best explains why the trader might use a currency
option rather than a currency future to hedge this transaction?
A The value of currency futures can be highly volatile.
B The counterparty to a financial future might default and leave the position
exposed.
C An option will provide scope for an upside if the Euro strengthens.
D An option will provide scope for an upside if the Euro weakens.

[2]
2 Which of the following is an unsystematic (specific) risk?
A Interest rates may change.

B Company directors may make bad decisions.
C Consumer demand can be affected by global economic cycles.
D Basic commodity prices can change.
[2]
3 A company has a policy of investing in projects on the basis of their internal rate of
return (IRR). Which of the following is a drawback of using IRR?
A Positive net present value projects may be rejected.
B High yield investment opportunities may be overlooked.
C IRR is more difficult to interpret than Net Present Value (NPV).
D Ranking mutually exclusive projects on the basis of IRR may give misleading
results.
[2]
CT2 S2013–2
4 Which of the following best illustrates an opportunity cost?
A Accepting a project with a negative net present value.
B Rejecting a project with a positive net present value because of funding

constraints.
C Understating the projected return on a potentially positive net present value

project in order to adjust for risk.
D Rejecting a project with a positive net present value because it has been
decided to invest the available funds in a different project.
[2]
5 Use the following information to calculate return on capital employed.
Profit before interest and tax £40m

Interest £8m
Ordinary shares £110m
Retained earnings £300m
Revaluation reserve £22m
Long term borrowings £90m
A 6.1%
B 6.4%
C 7.7%
D 8.0%
[2]
6 What is the most realistic interpretation of a low interest cover ratio in a highly cash
generative business?
A Any fluctuation in operating profit will lead to a greater fluctuation in earnings

per share.
B The company may be unable to meet its loan repayments.
C The company may be unable to pay its interest.
D The company may be in breach of its debt covenants.

[2]

7 What is the difference between profit and comprehensive income?
A Profit is calculated in accordance with International Financial Reporting

Standards (IFRS) and comprehensive income is not.
B Comprehensive income covers a longer period than profit.
C Profit must be disclosed but comprehensive income need not.
D Comprehensive income includes unrealised gains that are excluded from

profit.
[2]
8 An external auditor cannot conduct an adequate audit because the directors have
withheld a significant amount of vital audit evidence. What form of external audit
report would be appropriate in these circumstances?
A Adverse opinion
B Disclaimer of opinion
C Emphasis of matter
D Except for opinion
[2]
9 Which of the following best summarises the difference between straight line and
reducing balance depreciation?
A Reducing balance will lead to a higher charge in the short term after fresh
investment in assets and a higher total charge over the life of the assets.
B Reducing balance will lead to a lower charge in the short term after fresh
investment in assets and a higher total charge over the life of the assets.
C Reducing balance will lead to a higher charge in the short term after fresh
investment in assets but the same total charge over the life of the assets.
D Reducing balance will lead to a higher charge in the short term after fresh
investment in assets but a lower total charge over the life of the assets.
[2]
10 Who makes the final decision as to whether International Financial Reporting

Standards are used as the basis for accounting in any given country?
A The International Accounting Standards Board (IASB)

B The national government
C Professional accountancy bodies
D The national stock exchange
[2]
CT2 S2013–4
11 Describe the advantages of establishing a business as a limited liability partnership
rather than a traditional partnership. [5]
12 A quoted company has a policy of making relatively small dividend payments, with
profits being reinvested in the business. A period of slow growth in the industry has
left the company with a substantial cash surplus as a result of this policy.
Discuss the advantages to the company and shareholders of reducing this surplus by
means of a share buyback rather than a dividend payment. [5]
13 An investor has a policy of investing in a number of companies only in the oil and gas
industry. She believes that she knows this sector well and that her portfolio has been
well diversified internationally.
Discuss the logic of the investor’s investment strategy. [5]
14 Discuss the difficulties associated with charging tax on “fringe benefits” to

employees. (“Fringe benefits” can be thought of as non-monetary rewards – they
exclude wages and salaries.) [5]
15 A quoted company’s chief engineer has identified an opportunity to develop a project

that will offer a huge competitive advantage. Even a conservative estimate of net
present value shows that this is likely to be a successful investment. The directors
have advised the engineer that they will not proceed with the project because it will be
difficult to explain to the shareholders. The technology is simply too difficult to
understand and there will be a five year development phase.
Discuss the logic of the directors’ position with respect to this project. [5]
16 Discuss the assertion that the cash flow statement is unnecessary because it is easy to
see whether the closing bank balance is higher or lower than the opening bank
balance. [5]
17 A famous accounting scandal involved a company’s decision to recognise the

premiums from the sale of holiday insurance contracts when the contracts were sold,
rather than waiting until after the customer’s safe return from holiday (which was the
normal practice followed by other companies). There were no specific accounting
standards to deal with this matter.
Discuss the issues associated with recognising the profit from the sale of travel
insurance in this way in terms of accounting concepts. [5]

18 Alpha is reviewing bids for the construction of a major civil engineering project. One
of the shortlisted bidders is Global (Midlands) PLC (“Global”). Alpha is concerned
that Global may not have the necessary financial resources to complete this project
and has asked for reassurance. Global’s response is that the company is part of the
Mega Group, whose parent company is quoted and is based in Alpha’s home country.
Global has submitted the Mega Group’s latest consolidated financial statements to
demonstrate the solvency of the group.
Discuss the extent to which Alpha should rely on the Mega Group’s consolidated
financial statements in determining Global’s ability to service this contract. [5]
19 Paul has developed and patented a new product. He requires finance in order to put
the product into production. A venture capital company has offered to finance Paul
on the basis that Paul will incorporate his business as a limited company. The venture
capitalist will provide all of the funding necessary to commence the manufacture and
sale of the new product in return for 51% of the equity in this new company. The
venture capitalist will appoint a board member and Paul will also be a director of the
company. Paul will sign a five year employment contract with the company.
Paul’s role with the company will be to work on improvements to the original product
and to develop new products for sale by the company. In addition to working full-
time as an employee, he must patent any new ideas in the company’s name.
The company will be independently valued at the end of its first five years. The
venture capitalist will then offer Paul the opportunity to buy its 51% holding for that
proportion of the independent valuation plus 20%. If Paul does not take that offer
then the venture capital company will retain its shareholding and the question of
Paul’s contract will be reviewed by both sides.
(i) Discuss the benefits of this arrangement to both Paul and the venture
capitalist. [10]
(ii) Discuss the difficulties associated with the valuation of the company’s shares
at the end of year five. [5]
(iii) Recommend the approach that should be taken to valuing the company at the
end of year five. [5]
[Total 20]
CT2 S2013–6
20 Trent makes signs and banners for use in decorating venues for wedding receptions
and parties. Until recently, most of Trent’s sales were to private individuals who paid
for their purchases in cash or by credit card. During June 2013, Trent started to sell
its products to a major event planning company, who now buy their signage and
banners from Trent and who insist on trading on credit terms.
Trent’s directors are delighted at the massive expansion in sales, but they are starting
to become concerned about the impact on liquidity. The following information has
been extracted from the company’s monthly management accounts:
June 2013 July 2013 August 2013

£ £ £
Sales revenue
Credit sales to event company 400,000 850,000 1,213,000
Credit card sales 240,000 250,000 270,000
Cash sales 50,000 60,000 70,000
Total 690,000 1,160,000 1,553,000
Cost of sales 414,000 696,000 931,800
Inventory 358,800 583,742 781,510

Trade receivable from event company 200,000 765,000 1,273,000
Trade receivable from credit card
company 360,000 395,161 461,613
Bank 18,423
937,223 1,743,903 2,516,123
Trade payables 621,000 898,065 1,052,032

Bank 65,616 62,667
621,000 963,680 1,114,699
(i) Analyse Trent’s liquidity over the period covered by the extracts from the
management accounts. [12]
(ii) Recommend a suitable course of action for the management of Trent’s

liquidity. [8]
[Total 20]
END OF PAPER
CT2 S2013–7
EXAMINERS’ REPORT

Core Technical
Introduction
The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.
D C Bowie
December 2013
 Institute and Faculty of Actuaries

Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report
The general performance was similar to results in the past, well-prepared candidates scored
well across the whole paper. As in previous diets, overseas candidates did not perform quite
so well as UK candidates. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Candidates approaching the
subject for the first time are advised to include these areas in their revision. The main
problems were Q19 and 20, although many candidates scored high marks in all questions.
Page 2
1 C
2 B
3 D
4 D
5 C
6 A
7 D
8 B
9 C
10 B
Workings for Question 5
A = (40  8)/(200 + 300 + 22) = 6.1%

B = (40  8)/(200 + 300) = 6.4%
C = 40/(200 + 300 + 22) = 7.7%
D = 40/(200 + 300) = 8.0%
Questions 1–10 were done well by most candidates.
11 The LLP structure protects the members from claims against their personal wealth.
The LLP is a separate legal entity and its creditors cannot pursue the partners if the
LLP’s assets prove insufficient. That is a significant advantage because the partners in
a traditional partnership are jointly and severally liable in a personal capacity. The
actions of one partner could impose enormous personal liabilities on all of the others.
The only real exception is when an individual partner behaves recklessly or
dishonestly. In that case he or she may be personally liable to compensate any injured
party.
12 Dividend policies tend to attract shareholders on the basis of their tax preferences. A
company that pays little or no dividends will attract shareholders who prefer to
receive capital gains. A share buyback would possibly leave the shareholders open to
a claim for capital gains tax, but the funds released would not be income. There is a
further issue with respect to signalling. The buyback does not imply that future
dividends will be increased and so there is no question of misleading and
inconvenient signals being sent to the shareholders.
This question was done reasonably well by most candidates.
Page 3
13 The investor’s portfolio is not properly diversified. The capital markets do not offer
any return for accepting unsystematic risks because they can be diversified away. This
investor has accepted the risks borne by the oil and gas industry, but there will be no
benefit in the form of a higher return for this risk. The portfolio offers some
geographical diversification, but even that will be restricted to the countries that have
quoted oil or gas companies. This policy is only sound if she can genuinely identify
mispriced securities in this industry. Such an investment strategy is speculative.
There were some very good answers by candidates to this question.
14 One problem is in determining a value for those benefits. In some cases that could be
linked to the costs involved. For example, providing access to a company gym could
be viewed as a fringe benefit, but it will be very difficult to measure the value
obtained. This can lead to complicated arrangements, such as those relating to the
personal use of company cars in the UK, where records have to be maintained and the
tax authorities have to dictate the basis upon which the benefit should be provided.
There will be compliance problems because it may be difficult to maintain adequate

records of all of the benefits enjoyed by each of the employees.
There may also be motivational issues, if employees do not perceive the full value of
the benefit, but do see a cost in the form of a higher tax charge.
This question was not done very well by some candidates. In general candidates found it
difficult to write more than a short sentence or two. Benefits in kind are an important part of
the tax system.
15 Strictly speaking, the acceptance of a positive NPV project should increase the share
price. That will only be the case if the acceptance of the project is known and
understood and the shareholders agree with the directors’ evaluation. The company
may not wish to furnish the markets with details of this project for fear of attracting
competition. If the directors make an unsupported statement that profits are expected
to rise then the shareholders may dismiss that as self-serving disclosure by the board.
The decline in profits and cash flows in the short term will be observable and those
may affect the share price.
This question was answered well by many candidates. The link between positive NPV, share
price and the problems of disclosure was discussed reasonably well.
16 The comparison of the opening and closing balances can reveal a net cash inflow or
outflow, but cannot show the reasons for that change. A cash flow statement provides
the reader with details of the extent to which the operating activities are generating (or
consuming) cash. The cash flow statement also shows the other cash flows, broken
down into relevant categories. Thus, the cash flow statement can highlight the fact
that a net cash inflow occurred because the company has raised fresh borrowings. The
statement can also show how that cash inflow was applied. The cash flow statement
Page 4
makes it easier to reveal whether the net movement was attributable to the working
out of a business strategy (e.g. the deliberate investment of surplus cash) or the first
sign of a problem (e.g. cash flow problems).
This question was answered very well.
17 The basic problem with this case is the decision as to when a profit has been earned.
The realisation concept would suggest that the sale of a policy is a significant part of
recognition. The company would not sell insurance if doing so was unprofitable.
Prudence would suggest that no profit be recognised on an insurance contract until
such time as the company knows whether or not there will be a claim, which is likely
to be shortly after the customer’s safe return. The accruals concept suggests that it
would be ideal if the costs could be recognised in the same period as the revenue. The
easiest way to do that would be to wait until after the date of travel. It could be
possible to estimate the costs of potential claims and create a provision at the time of
sale. The money measurement concept would make that feasible if the estimate was
deemed to be reasonably accurate.
This question was answered reasonably well by many candidates.
18 Groups of companies are not legal entities as such and so it is impossible to have a
direct relationship with a group. Alpha’s relationship will be with one group member,
Global. Alpha cannot take it for granted that Mega will support Global in the event
that it runs into difficulties and finds itself incapable of meeting its commitments. It
may be of some comfort to know that Global is part of a large group because it may
not be in Mega’s interest to permit Global to fail. If Alpha really intends to rely on
that possibility then it should seek written assurances that Mega will guarantee
Global’s future.
This question was not answered as well as expected.
19 (i) Paul will have the advantage of equity finance. The venture capitalist cannot
demand repayment in the event of short-lived cash flow problems. Paul may
also be able to request further financial support from the venture capitalist in
the event of any unforeseen contingencies. The venture capitalist has an
incentive to support the business because of the prospect of the capital gain in
the event of it being a success.
Paul will also benefit from the provision of an experienced director, who will
provide advice to the business while it is growing. That will leave Paul free to
work on developing and marketing the product.
The venture capitalist has the opportunity to make a substantial return if this
product proves a success. The cost of acquiring this right is linked to the cost
of setting up initial manufacturing and so it may not reflect the full value of
the product’s patent.
Page 5
Paul will be committed to this business, partly because of the contract and
partly because of the right to buy back the equity. The venture capitalist would
probably find it difficult to attract such an entrepreneur without offering an
equity stake in this manner.
This is a risky investment, but the downside is restricted to the initial

investment and there is a very substantial upside.
This question was answered very badly by several candidates. A lack of knowledge of this
subject area was demonstrated.
(ii) Both parties will be at odds with one another over the valuation. Both will
wish to influence the independent valuer, who will have to draw upon
internally generated information and reports in order to undertake this
valuation exercise.
Paul may indulge in dysfunctional behaviour in order to lower the valuation in

the lead-up to the valuation date. New products in development may not be
revealed or may be made to look unprofitable.
The basic problem is that there will be no independent basis for the valuation
of the company. The lack of a market price means that the valuation exercise
will be highly subjective. There are likely to be a variety of different valuation
models and each will provide a different figure.
This part was done reasonably well.
(iii) One approach would be to identify one or more quoted companies that are
innovators in product design in the same area as this business. These
companies’ price/earnings ratios will be a matter of record. The business’
latest reported profit figure could then be multiplied by this comparator’s P/E
to give an estimated valuation.
The benefit of this approach is that it links valuation to profits and earnings,
which appears to be the focus of the business. It relates the value of the shares
to the most recent results of the business. It may be necessary to adjust profit
to allow for the possibility that there have been unusual transactions or that
there is a clear expectation of future growth.
Any valid alternative approach would be awarded credit.
This part of the question was poor with candidates finding it difficult to think of anything to
discuss.
Page 6
20 (i)
June July August
Current ratio 1.5 1.8 2.3

Event company receivable turnover (days) 15 28 33
Credit card receivable turnover (days) 45 49 53
Inventory turnover (days) 26 26 26
Trent’s current ratio actually looks healthy. The problem is the composition of
current assets. The event company owes Trent a great deal of money. That
appears as a current asset, but recovery times are slowing dramatically. Trent
is also very exposed to the failure of the company’s one credit customer.
The credit card company is also slowing down its payments to Trent. That is a
further reason for the net outflow of cash.
Inventory turnover continues from month to month at a steady pace and the
increase in inventory holdings is in line with production.
The overdraft is a major cause for concern because it is potentially repayable

on demand. Trent could easily find itself totally insolvent if it does not
improve its cash management.
The calculations of the ratios was done well by candidates the discussion was done less well.
(ii) The first question is whether it would be possible to press the event company
for more rapid payment. It looks as if the whole of August’s sales remain
unpaid. It may even be worth risking the loss of the company’s business if
Trent is going to wait so long for payment that overdraft interest swamps the
profit.
Trent should also press the credit card company. It may be easier to threaten to
move to another provider of this service.
It does not look as if matters are deteriorating with respect to inventory, but
running inventory down to less than 26 days’ holding would release cash.
Once there is greater clarity about the payment stream from both receivables,
Trent should consider raising finance to support the cash flow until the bank
account is back in credit. That may be a matter of negotiating a larger
overdraft or taking out a short-term loan. Even if the payables cannot be
collected any more quickly, matters will improve when the expansion ceases
and sales and cash flows settle to a steady equilibrium.
This part was done reasonably well.
Page 7

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Faculty of Actuaries Institute of Actuaries

29 April 2010 (am)

Subject CT2 — Finance and Financial Reporting

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

3. Mark allocations are shown in brackets.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

A The directors should maximise shareholder wealth and ignore externalities.

B The directors should maximise shareholder wealth and respect regulatory

D The directors should maximise social welfare.

A Business customers are unlikely to buy on cash terms.

3 In which of the following circumstances would it be inappropriate for a company to

A The company has a comparative advantage in borrowing at a fixed rate of

B The company has a comparative advantage in borrowing at a floating rate of

D The company wishes to create greater flexibility in the eventual settlement of

A Existing shareholders have nothing to lose.

A potential tax advantages to the company

A Equity investors accept greater risks.

A the board of directors

CT2 A2010—3 PLEASE TURN OVER

D Purchase goods for cash instead of on credit.

(a) Explain what is meant by “information asymmetry” in the context of limited

(b) Explain the role of financial reporting as a means of resolving information

12 An individual investor is considering making an investment in an investment trust, but

(a) Explain why the discount exists.

Describe the advantages and disadvantages to the company’s existing shareholders of

14 Describe the advantages of raising additional equity finance by means of a rights

15 A small company engaged a firm of consultants to evaluate a very complicated

16 Describe the purpose of a cash flow statement. [5]

CT2 A2010—5 PLEASE TURN OVER

Draft balance sheet as at 31 March 2010

EQUITY AND LIABILITIES

Total equity and liabilities 221

(iv) Discuss the advantages and disadvantages of revaluing non-current assets in

CT2 A2010—7 PLEASE TURN OVER

April 2010 Examinations

Subject CT2 — Finance and Financial Reporting

These are given in italics at the end of each question.

Questions 1–10 were answered well by most candidates.

The external financial statements are likely to be subject to an independent

be for many individual investors. Furthermore, the investment trust will

This question was answered well by many candidates.

14 A rights issue is targeted at shareholders who have already demonstrated their

This question was answered very well by most candidates.

This question was answered very well by most candidates.

18 Preparing financial statements involves making estimates and assumptions. For

This question was answered poorly.

Property, plant and equipment would be increased to £200m+90m = £290m.

(ii) Gearing (original figures) = (£50m+30m)/(161m+50m+30m) = 33%

Gearing (with revaluation) = (£50m+30m)/(161m+90m+50m+30m) = 24%

Valuation increases the subjectivity in the financial statements. Any valuation

Discount factor 1.000 0.935 0.873 0.816 0.763 0.713

Discounted cash flow (5.0) 1.1 1.0 1.0 0.9 1.4

Net present value = total = £0.4m

It should only have items that involve the movement of money.

END OF EXAMINERS’ REPORT

11 October 2010 (am)

Subject CT2 — Finance and Financial Reporting

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

3. Mark allocations are shown in brackets.

5. Candidates should show calculations where this is appropriate.