Subject CT2: CMP Upgrade 2012/2013

CT2: CMP Upgrade 2012/13 Page 1
The Actuarial Education Company IFE: 2013 Examinations

Subject CT2

CMP Upgrade 2012/2013

Purpose of the CMP Upgrade

This CMP Upgrade lists all significant changes to the Core Reading and the ActEd
material since last year so that you can manually amend your 2012 study material to
make it suitable for study for the 2013 exams. It includes replacement pages and
additional pages where appropriate. Alternatively, you can buy a full replacement set of
up-to-date Course Notes at a significantly reduced price if you have previously bought
the full price Course Notes in this subject. Please see our 2013 Student Brochure for
more details.

This CMP Upgrade contains:

All changes to the Syllabus objectives and Core Reading.
Changes to the ActEd Course Notes, Series X Assignments and Question and
Answer Bank that will make them suitable for study for the 2013 exams.

Page 2 CT2: CMP Upgrade 2012/13
IFE: 2013 Examinations The Actuarial Education Company
1 Changes to the Syllabus objectives and Core Reading
1.1 Syllabus objectives
Objective (x) 2 has been updated to replace income cover with interest cover and
now reads:

(x) Interpret the accounts of a company or a group of companies and discuss the
limitations of such interpretation.

2. Calculate and explain interest cover and asset cover for loan capital.

Objective (ix) 4 has been amended to require the understanding and interpretation of
cashflow statements, rather than their construction, and now reads:

(ix) Describe the basic construction of accounts of different types and the role and
principal features of the accounts of a company.

4. Construct simple statements of financial position and income statements;
understand and interpret cashflow statements.

The list of further reading for Subject CT2 has been revised by the Institute and Faculty
of Actuaries. It now suggests the following:

Accounting and finance for non-specialists. Atrill, P.; McLaney, E. 7th ed. Prentice
Hall, 2010. 576 pages. ISBN: 978-0273745964

Fundamentals of financial management (concise edition). Brigham, E. F.; Houston, J . F.
7th ed. South-Western, 2011. 384 pages. ISBN: 978-0538481526

How to understand the financial pages. Davidson, A. 2nd ed. Kogan Page, 2008. 369
pages. ISBN: 978-0749451448

Interpreting company reports and accounts. Holmes, G.; Sugden, A.; Gee, P. 10th ed.
336 pages. FT Prentice Hall, 2008. ISBN: 978-0273711414

Principles of corporate finance (Global edition). Brealey, R. A.; Myers, S. C.; Allen, F.
10th ed. McGraw-Hill, 2010. ISBN: 978-0071314176

1.2 Core Reading
Chapter 3

Page 13

In Section 3.2, please amend the final sentence of the first paragraph to read:

In the UK, from 6 April 2008, a flat rate of 18% or 28% will apply to capital gains
above the allowance, depending on the level of taxable income.

Page 16

Please amend the box of Core Reading to read:

Double taxation relief (DTR) means that the local tax authority will allow
companies and individuals with overseas income or capital gains to offset tax
paid overseas against their liability to domestic tax on that income or capital
gains.

In the line after the box, please delete the phrase on the grossed-up income.

Please delete the following sentence of Core Reading:

DTR is only available on income received from abroad, not on revenue of a
capital nature.

Chapter 7

Page 17

In Section 4.3, on the second line, please replace the Department of Trade and
Industry with the Department of Business, Innovation and Skills.

Pages 20-21

The Core Reading on the cost concept has changed. Replacement pages (pages 1922)
are provided at the end of this pack. Please keep your original page 22 for information
on the dual aspect concept.

Chapter 8

Page 16

In Section 2.8, in the third line of Core Reading, please insert (usually profit after
tax) after shareholders so that the second sentence reads:

EPS is equal to the earnings attributable to the ordinary shareholders (usually,
profit after tax) divided by the number of ordinary shares in issue.

Pages 17-26

In Section 2.10, there is new Core Reading on other comprehensive income.

In Section 3.1, there is new Core Reading on the importance of cashflow statements.

In Section 3.2, there is new Core Reading on the interpretation of the cashflow
statement.

Replacement pages (pages 1730) are provided at the end of this pack.

Chapter 9

Page 11

The Core Reading on revaluation has been simplified. Please delete all the Core
Reading on this page.

Chapter 10

Page 7

At the end of the opening paragraph, please insert and understanding and
interpreting a before cashflow statement. The final sentence should read:

This section is, therefore, intended to give only a brief overview of the
mechanics of preparing an income statement, statement of financial position and
understanding and interpreting a cashflow statement.

Page 12

In Section 2.2, please delete the second paragraph of Core Reading.

Chapter 12

Page 7

Please change income to interest in income cover and income priority
percentages four times.

Page 9

Please change income to interest in income priority three times.

Page 15

Please change income to interest towards the end of the first paragraph of Core
Reading.

Page 24

Please change income to interest at the bottom of the page.

Chapter 14

Page 4

At the end of the top line please replace have now been with were.

In the third line, please delete now.

Page 8

In the first line at the top of the page, please replace FSA with regulator.

Page 12

Under Regulating companies, in the second line, please replace FSAs with
regulators.

Page 14

There is a new section of Core Reading on derivatives exchanges (Section 3) and the
subsection on discount houses has been removed. Replacement pages (pages 1314)
are provided at the end of this pack. Please keep your original page 14 for information
on investment banks.
Page 15

Towards the bottom of the page, under Other please add the following bullet:

act as counterparties / brokers for Over-The-Counter (OTC) derivative
contracts, a facility used mainly by pension funds and insurance funds.

Page 27

There is new Core Reading on open-ended investment companies. Replacement pages
(pages 2728) are provided at the end of this pack. Note that the numbering has
changed: institutional investors are now in Section 4; and, with the removal of discount
houses, open-ended investment companies are now in Section 4.6.

Page 31

At the end of the first paragraph, please add the following sentence:

Due to the shift from defined benefit to defined contribution schemes, together
with volatile equity markets, the proportion of pension funds assets invested in
equities is falling.

Page 33

At the top of the page, in the first paragraph, please delete the second sentence of Core
Reading.

Chapter 19

Page 9

Please change income cover to interest cover twice.
2 Changes to the ActEd Course Notes
Chapter 2

Page 6

The purpose and content of the Memorandum of Association has changed. Details of
the changes are given. Replacement pages (pages 510) are provided at the end of this
pack.

Chapter 3

Page 7

In Section 1.3, in the fourth line, please change the year to 2012-13.

Page 9

In Section 2.2, please change the standard rate of corporation tax to 24% for the tax year
2012-13.

Page 13

Under Allowances, please change the year to 2012-13.

Page 16

In the example box, please change the rate of corporation tax to 24%. Please amend the
second example to read:

XYZ earns 10,000 in France where it is subject to 20% tax. In the UK the 10,000
(or 8,000 after French tax) will be subject to an additional 4% tax. So, XYZ will end
up with 7,600 after UK tax.

Page 18

Please amend the final sentence to read:

These agreements allow companies and individuals with overseas income or capital
gains to offset tax paid overseas against their liability to domestic tax on that income or
capital gains.

Page 21

In the solution to Question 3.8, please delete the second and the fourth bullet points and
add the following two:

Applies to individuals and companies.

Applies to income and capital gains.

Chapter 4

Page 41

In the solution to Question 4.12(b), in the first two lines, please delete: stated in the
Memorandum of Association. It is so that the first sentence reads:

The authorised share capital of a company is expressed as a nominal value, ie x shares
of y par value.

Chapter 8

Page 1

Please amend the syllabus objectives to read:


Pages 17-30

The sections on other comprehensive income, revaluation and the cashflow statement
have been rewritten in the light of new Core Reading.

In Question 8.6, the tax rate has changed to 24%.

In Question 8.10, an additional task has been set.


Page 34

Please correct the figure for total liabilities. It should be 421,000.

Pages 35-42

The solutions to a number of questions have been changed. Replacement pages
(pages 3542) are provided at the end of this pack.

Chapter 9

Page 9

In Section 2.2, just above Question 9.5, please delete the sentence reading:

Note that this was the business assets approach we saw described in Chapter 8.

Page 11

The material on revaluation has been simplified. Please delete the section headed The
revaluation of assets held as investments - the entire page!

Page 13

In Question 9.7(ii), please delete the second part of the question after the comma, so that
it reads: (ii) with revaluation of the non-current assets.

Page 20

In the solution to Question 9.6, under the case against, please delete the third bullet
and the note in italics at the bottom of the solution.

Chapter 10

Page 1



Chapter 12

Page 1


2. Calculate and explain interest cover and asset cover for loan capital.

Pages 7-10

Please change income to interest in income cover and income priority
percentages.

Page 43

Please change the heading of Section 9.3 to read: Creditors turnover period.

Chapter 14

Page 2

Towards the bottom of the page, before the exam hint, please amend to read:

Section 2 covers the Stock Exchange, Section 3 covers the derivatives exchanges and
Section 4 covers other institutions.

Page 4

After the Core Reading at the top of the page, you might like to add the following:

In an overhaul of the regulatory system, announced in 2010 and to be in place by 2013,
the FSA is to cease to exist in its current form and the regulatory functions are to be
returned to the Bank of England.

Pages 37-40

Derivatives exchanges and open-ended investment companies have been added to the
summary. Replacement pages (pages 3740) are provided at the end of this pack.

Chapter 16

Page 17

In the box, please correct the figure for the increase in retained earnings. It should be
224,000.

3 Changes to the Q&A Bank

Part 1

Question 1.1

Please change I to read:

I the intention of the subscribers to form a company

Solution 1.1

Please change the solution to read:

Answer =C

Since 2009, the Memorandum of Association simply confirms the subscribers intention
to form a company and become members of that company on formation.

Solution 1.30

On page 9, under Documentation, please amend the third sentence to read:

A company must have three formal legal documents (Memorandum of Association,
Articles of Association and Form IN01) and be registered at Companies House.

Solution 1.38

Please change the second sentence to read:

Both are traded on derivative exchanges, such as LIFFE. [1]

Part 2

Question 2.24

On page 11, please add the following to the table:

increase in cash 3,950

Solution 2.24

On page 13, replace Note 5 with the following:

5. 12,825 from last years statement of financial position plus 3,950 increase in
cash.

Please delete the note in italics at the bottom of the solution.

Question 2.26

On page 15, please add the following to the table:


Solution 2.26

On page 18, in the cash entry, please add the calculation in the final column as follows:

Cash 79,000
40,000 +39,000

On page 19, please delete the calculation of cash in Note 1 and delete the note in italics
at the bottom of the solution.

Question 2.27

On page 17, at the end of the question, please add the following:

Note: You will not be asked to construct a cashflow statement in the exam, but you
might find it useful to have the experience.

Part 3

Question 3.4

The figures have been multiplied by 365 to give stock turnover period. Please amend
the question to read:

The stock turnover period using average levels of inventory over the year is:

A 102 days
B 223 days
C 599 days
D 850 days [2]

Solution 3.4

The answer in unchanged. Please amend the calculation to read:

Average stock turnover period is:

11,500
365 365 600
7,000
average inventory level
days
cost of sales
= = [2]

Question 3.28

On page 13, please amend the fifth bullet point to read:

Inventories increased by 4,500 and trade receivables increased by 10,000. Trade
payables increased by 17,000. The company reduced its overdraft by 15,000 and
reduced its cash balance by 90,500.

Please delete part (ii) of the question. The total mark for the question is now 17.

Solution 3.28

On page 16, in the cash entry, please add the calculation in the final column as follows:

Cash 34,500
125,000 90,500

Please delete the solution to part (ii) on page 17.

Question 3.31

A new question has been added to meet the new syllabus requirement. Replacement
pages (pages 1920) are provided at the end of this pack.

Solution 3.31


Part 5

Question 5.3

This question has been changed. Replacement pages (pages 12) are provided at the
end of this pack.

Solution 5.3

The answer is unchanged. The explanation for the new question is as follows:

An advantage of recourse factoring is that the factor provides for the early payment of
invoices, but a disadvantage is that the supplier retains the credit risk.

Question 5.4

The tax rate has been changed. Replacement pages (pages 12) are provided at the end
of this pack.

Solution 5.4

The answer is unchanged.

Solution 5.16 (i)

On page 10, please delete Note 4.
4 Changes to the X Assignments
The marks allocated to particular points of some of the solutions have changed, but the
subtotals and totals have remained the same.

Assignment X1

Solution X1.13

The solution has changed in the light of new Core Reading. Replacement pages (pages
78) are provided at the end of this pack.

Assignment X2

Solution 2.11

On page 5, under The cost concept, please add the following:

The cost concept has been gradually phased out in order to provide more scope for
realism in the financial statements. []

Question X2.16

Please increase the marks for part (i) to 7. The second part of the question has changed
in the light of new Core Reading. Replacement pages (pages 78) are provided at the
end of this pack.

Solution X2.16

The solution has changed. Replacement pages (pages 1316) are provided at the end
of this pack.

Assignment X3

Income cover has been replaced by interest cover throughout.

Solution 3.10

In the formula, please replace ratio with period.

Assignment X4

Question 4.2

Towards the end of the first paragraph, please delete the companys cost of debt is
8%.

At the beginning of the second paragraph, please insert: Assuming that the company
can borrow at the risk-free rate and ...

Please change the answers to: A 10.5%; B 12%; C 14%; D 15.5%.

The full question should now read as:

The structure of XYZ is such that the company has $75 million of shareholders capital
and reserves and $25 million market value of outstanding debt. These funds are
invested in a diversified portfolio of assets, which are expected to earn a return no more
or less than the market. The risk-free rate of return in the market is 6% and investors
expect the market to give a return of 12%.

Assuming that the company can borrow at the risk-free rate and that there are no taxes,
the return expected from the equity shares in XYZ is:

A 10.5%.
B 12%.
C 14%.
D 15.5%. [2]

Solution 4.2

The solution has changed and has been extended. Replacement pages (pages 12) are
provided at the end of this pack. Please keep your original pages for the full solution to
Question 4.4.

Question 4.19(ii)

In the second and third lines, please change in to under.

5 Other tuition services

In addition to this CMP Upgrade you might find the following services helpful with
your study.

5.1 Study material

We offer the following study material in Subject CT2:
Mock Exam
Additional Mock Pack
ASET (ActEd Solutions with Exam Technique) and Mini-ASET
Sound Revision
Revision Notes
Flashcards.

For further details on ActEds study materials, please refer to the 2013 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.

5.2 Tutorials

We offer the following tutorials in Subject CT2:
a set of Regular Tutorials (usually lasting two or three full days)
a Block Tutorial (lasting two or three full days)
a Revision Day (lasting one full day)
an online classroom.

For further details on ActEds tutorials, please refer to our latest Tuition Bulletin, which
is available from the ActEd website at www.ActEd.co.uk.

5.3 Marking

You can have your attempts at any of our assignments or mock exams marked by
ActEd. When marking your scripts, we aim to provide specific advice to improve your
chances of success in the exam and to return your scripts as quickly as possible.

For further details on ActEds marking services, please refer to the 2013 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.
6 Feedback on the study material
ActEd is always pleased to get feedback from students about any aspect of our study
programmes. Please let us know if you have any specific comments (eg about certain
sections of the notes or particular questions) or general suggestions about how we can
improve the study material. We will incorporate as many of your suggestions as we can
when we update the course material each year.

If you have any comments on this course please send them by email to CT2@bpp.com
or by fax to 01235 550085.

CT2-02: Company ownership Page 5

Legal and accounting documentation

Most partnerships will have a partnership agreement which sets out the rights
of individual partners, such as who can make what decisions and how profits are shared
between partners. Strictly, no specific documentation is needed. The partnership will also
need to provide accounts so that Her Majestys Revenue and Customs (HMRC) can
work out each partners liability to tax on their share of the partnerships profits. Partners
pay income tax.

A new form of partnership was introduced in 2001. The limited partnership is discussed
after we have discussed the limited company.

1.3 Limited companies
A limited company is a business which has a legal identity separate from the
owners of the business.

Description

A limited company has its own distinct legal identity. It can own or deal in property in its
own right. It can arrange contracts on its own behalf. It can also sue and be sued. A
company can be fined by the court (but not imprisoned!).

Almost all limited companies are set up by the issue of shares. The owners of the
company are called shareholders. Each shareholder will hold a certificate showing
how many shares they own in the company. Most shares give the right to vote at
company meetings. The shareholders will appoint directors who are responsible
for the control of the company on behalf of the shareholders. The company is run
by managers who carry out the directors policies on a day to day basis. Managers are
often elected as directors, in which case they are known as executive directors. Directors
who are not involved on a daily basis are known as non-executive directors.

In most cases, shares in a company may be purchased and sold without the permission of
the other shareholders. Shareholders will not generally be actively involved in the
running of the company. These statements are more true of public limited companies than
of private limited companies (we discuss these two types of company in a later section).

Page 6 CT2-02: Company ownership

Profits will be declared each year and a dividend will usually be paid to each
shareholder in proportion to the number of shares they own. It is common for
dividends to be paid in two instalments: an interim payment made halfway through the
year and a final payment at the end of the year once the accounts have been finalised. The
total amount of dividends is usually less than the profits for the year, the balance being
retained in the company on behalf of the shareholders. However, the amount of dividends
can be the same or even greater than the profits (dividends can exceed profits in a
particular year if there are sufficient retained profits from previous years).

Liability

The owners liability is limited to the fully paid value of their shares. Shareholders
in a limited company have their liability limited to the fully paid value of their shares. So
that, if shares have been issued partly-paid then, in the event of a liquidation,
shareholders will only be liable to pay the outstanding instalments. If the shares
are fully paid , the shareholders have no further liability. If shares have been
issued at a premium to their par value, the whole of this share premium is
payable at the outset, even if the shares are issued on a partly-paid basis. If
the company becomes insolvent, creditors cannot claim further payment from the
shareholders personal wealth beyond the fully paid value of their shares.


Limited companies must have a Memorandum of Association and Articles of
Association.

Prior to 2009, the Memorandum of Association included a lot of detail such as the name
of the company, its objectives and its total share capital. However, since 2009, the
Memorandum of Association simply confirms the subscribers intention to form a
company and become members of that company on formation. Members have to agree
to take at least one share each in the company. Once the company is incorporated, the
Memorandum of Association is regarded as a historical document that cannot be
amended and does not affect the company going forward.

The Articles of Association lay down the internal rules by which the directors run the
company and set out the rights of owners of the different classes of share capital. The
contents include internal arrangements such as voting rights of different classes of shares,
rules for electing directors, payment of dividends and winding-up provisions.

Since 2009, a third document must be completed. Form IN01 is an application form to
register a company and contains many of the details that used to be included in the
Memorandum of Association, such as the company name, the registered office and the
share capital details.

Once the above documents have been submitted to Companies House, a certificate of
incorporation will be issued. The certificate is conclusive evidence that the
requirements of the Companies Act 2006 as to registration have been complied with and
that the company is duly registered under this Act.

All companies above a certain size (in terms of turnover or assets) must produce
audited accounts each year.

Companies pay corporation tax on the profit earned. Employees pay income tax on
wages and salaries earned.

1.4 Limited liability partnerships
A new corporate identity, the Limited Liability Partnership (LLP), was introduced
in the UK in 2001.

This is a business vehicle that gives the benefits of limited liability whilst
retaining other characteristics of a traditional business partnership.

Description

Any firm consisting of two or more members (note: not partners) engaged in a
profit-making venture, may become a LLP. Unlike limited companies, there are
no directors (or company secretary) and, of course, no shareholders.

The LLP, as with a limited company, is a separate legal entity. As a separate legal
entity, the LLP is able to enter into contracts, hold property and to continue in existence
regardless of changes in membership. Any third party dealing with a LLP makes a
contract with the LLP rather than with a member

Liability

Whilst the LLP itself is responsible for its assets and liabilities, the liability of its
members is limited. (As with companies, however, actions may be taken against
individual members who are found to be negligent or fraudulent in their
dealings.)



Unlike a limited company, a LLP has no Memorandum & Articles of Association.
In general terms, a LLP is governed by the partnership agreement that may
already be in force within an existing partnership. In the absence of any agreement,
the mutual rights and duties will be governed by the default provision contained in the
regulations.

Like a company, a LLP has to be registered at Companies House. An incorporation
document must be submitted and signed by at least two persons, who will become the
first members of the LLP. A LLP is required to appoint at least two designated
members who will be responsible for a number of duties in the running of the LLP such
as the signing and filing of the annual accounts.

The accounting and audit requirements for LLPs are similar to those for companies, for
example, financial disclosure for third parties dealing with the LLP and disclosure of
earnings of the highest paid member. Like a company, audited accounts must be
submitted if the LLP is above a certain size.

A LLP is taxed in the same way that partnerships are taxed. LLPs that do not carry
on business as a trade or profession, such an investment company, are subject to
corporation tax.

It is expected that LLPs will prove most attractive to professional firms (such as
accountants and solicitors). The UK has seen a steady flow of partnerships
incorporating as LLPs since the first conversion in 2001, with recent announcements
confirming that the rate of change is increasing as the LLP model becomes more widely
understood.

Question 2.1
Contrast the different types of liability which are characteristic of the following forms
of business entity:
sole trader
partnership
limited company
limited liability partnership.


Question 2.2
Draw up a table to compare a partnership, a limited liability partnership and a limited
company with respect to:
main source of finance
legal identity
liability
documentation
disclosure
tax.

1.5 Private and public limited company
Limited companies come in two forms, public limited companies and private limited
companies. The two forms of company are very similar. The difference is simply how
they register themselves. It is quite easy for almost any private limited company to re-
register as a public limited company. The legal definitions are set out in the Companies
Act 2006.

Public limited company

Public limited companies offer shares to the general public and shareholders have limited
liability.

A public limited company is a company whose Memorandum states that it is a
public company and which has an issued share capital of at least 50,000. The
name of a public limited company must end with the words public limited
company or the abbreviation PLC or plc.

A public limited company must be correctly registered with the Registrar of Companies
at Companies House. All public companies must produce audited accounts.

Each issued share must be paid up to at least a quarter of its par value plus the whole of
any premium on it.

Note that the definition does not have anything to do with whether the company is owned
by the public sector (ie government) or private sector although most public companies
are private sector companies.

Private limited company

All other limited companies are classed as private limited companies. A private
limited companys name must end with the word limited . A private limited
company is not allowed to offer its shares to the public.

Listed companies

It is a requirement of the Stock Exchange that a company that wants to have a
full Stock Exchange listing must be a public limited company. It is possible to have
an unlisted public company, but in practice most companies will go public and obtain a
listing on the Stock Exchange, allowing widespread dealing in the companys shares, at
the same time. (We will look at how companies obtain a Stock Exchange listing later in
the course.)

Consequently, most public companies are large companies whose shares are held by many
different shareholders who take no part in the companies day to day operations. Private
companies are more typically small companies with a narrow range of shareholders, often
being family run businesses.

Less common types of company

The following types of company also exist in the UK:

Companies limited by guarantee. Each members liability is limited to the
amount they have guaranteed, eg 100. These are often used to form clubs and
associations.

Companies established by Royal Charter.

Close company. A company under the control of five or fewer people. Both
private and public limited companies could be close.

CT2-07: Introduction to accounts Page 19

5 Accounting concepts
Accounting standards are based on concepts and conventions which have
gradually come together and evolved over many years since bookkeeping and
accountancy came into being. In recent years accounting standards bodies have
attempted to put more cohesion behind these concepts and conventions.

For example, the International Accounting Standards Board published IAS 1
Presentation of Accounting Statements and IAS 8 Accounting Policies,
Changes in Accounting Estimates and Errors .

In recent years Accounting Standards have placed greater emphasis on
neutrality, rather than prudence, and there has also been a move away from
historical cost towards fair values .

In very broad terms, this means revaluing assets (and liabilities) in the statement
of financial position at the end of each accounting period. Any loss on
revaluation should be included in that periods income statement. Any gain on
revaluation is taken to the revaluation reserve in the statement of financial
position, where it is held until the gain is realised (ie the asset is sold). A
consequence is volatility in the financial statements and so this move is
controversial.

We will discuss revaluation further in Chapters 8 and 9.

The 11 accounting concepts we discuss in detail are:
the cost concept (often called historical cost)
the money measurement concept
the business entity concept
the realisation concept
the accruals concept
the matching concept
the dual aspect concept
the materiality concept
prudence
the going concern concept
consistency.
Page 20 CT2-07: Introduction to accounts

As you read each concept, dont just memorise the text try to visualise what the
consequences of the concept would be if you were drawing up the accounts of a small
manufacturing company, billing customers, receiving invoices from suppliers and trying
to complete quarterly accounts at the same time.

5.1 The cost concept
The cost concept has been presented as one of the cornerstones of accounting
for a very long time. Under that concept, non-current assets generally appear in
the statement of financial position at their original cost less depreciation to date,
subject to a possible impairment write-down.

For most non-current assets such as machinery, manufacturing properties,
computers etc, the cost concept dictates that any expenditure in acquiring them is not
taken as a cost in the year in which the asset is purchased. Instead an amount of
depreciation is calculated each year and taken as a cost through the income statement.
The asset is placed on the balance sheet, but its value is written down year by year as
the original cost is depreciated to zero.

Example

If a bond is purchased at 70 per 100 nominal, a strict reading of the cost concept
suggests that it should be held in the books at this price until it is sold or matures.
However a more appropriate policy might be to increase the book value gradually from
70 to 100 over the period to maturity. This avoids a large capital gain on redemption.
This is what is referred to as amortised cost, where amortisation refers to the gradual
death of the asset!

This would still be classed as a book value basis of accounting.

This cost convention ignores changes in the purchasing power of money and can
produce different values for identical items, but simplifies the task of maintaining
bookkeeping records because the original cost of an asset is normally a
straightforward matter to determine.

The cost concept has been gradually phased out in order to provide more scope
for realism in the financial statements. For example, tangible non-current assets
such as property, plant and equipment can be shown at their fair value rather
than their historical costs. That creates the risk of dispute over the accuracy of
the resulting figures because there are rarely transparent and visible markets to
enable the fair value of, say, a specific office block in London, Edinburgh or
Kuala Lumpur to be observed. Fair values will usually involve a degree of
judgement and will frequently be open to challenge.
CT2-07: Introduction to accounts Page 21

The movement from cost to fair value indicates that the accountancy profession
is constantly reviewing the advantages and disadvantages of competing
approaches. For example, cost was favoured in the past because it is generally
a defensible and reliable measure. There is now greater reliance on fair values
because they offer a more relevant measure of the value of the resources
controlled by the company.

For example, it would be over-prudent to allow land to remain at original cost in the
balance sheet if it is worth 10 times what the company paid for it. That is why fair
values are permitted for such assets.

5.2 The money measurement concept
Accounting statements restrict themselves to matters which can be measured
objectively in money terms. Again, this simplifies accounting enormously. It
also means that a statement of financial position will rarely give even a rough
approximation of the value of the business because it will exclude such items as
the values of the companys customer base, its workforce and its brand names.

5.3 The business entity concept
The affairs of the business are kept separate from those of the owners. This is
perfectly valid in the case of a limited company, which has its own legal identity.
It would, however, also apply to sole traders and partnerships where the
business does not exist except as part of the owners estate.

It seems common sense that the financial transactions of a business entity are
maintained separately from those of the owner. However it is useful to state it as an
accounting concept.

5.4 The realisation concept
Income is recognised as and when it is earned . It is not, therefore, necessary
to wait until the customer settles his or her bill. This avoids the fluctuations in
reported income which might arise if everything was accounted for on a cash
basis. It can also create the impression that the business is performing well
when, in fact, it is in danger of running out of cash. A business which is
expanding might report income long before the related cash inflows.

Page 22 CT2-07: Introduction to accounts

This concept runs alongside the accruals concept by emphasising the fact that profit
should be recognised in the period it is earned, rather than when the financial settlement
takes place. If a company has sold its products or services, then the sales should be
recognised in the accounts. The fact that the company might not have received payment
is an entirely separate concern. The profitability of the business is measured through
the income statement and the cashflow is dealt with through the cashflow statement and
the provision for bad debts.

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

Suppose for example, that on 1 February, a drug company pays the quarterly rental on
its development laboratories for the period February, March and April, then completes
its accounts for the year to March. The company would be justified in allocating only
two thirds of the rental payment in the period to the end of March.

Question 7.8
Would it be appropriate to spread the costs of a failed drug development over a 5-year
period?

5.6 The matching concept
Income and expenses which relate to each other should be matched together
and dealt with in the same income statement. From the above two concepts this
should be for the period in which the amounts were earned/incurred.

The matching concept is a mixture of the realisation concept and the accruals concept.
Expenditure incurred in generating the income for a period should be recorded as
incurred over the same period, ie the expenditure is matched to the income.

CT2-08: The main accounts Page 17

If the company raises some share capital from preference shares, then earnings will be
net profit after tax after the deduction of preference dividends.

We will examine earnings per share in more detail in Part 3 of the course.

2.9 Realised capital gains (and losses)
If the company sells an asset for an amount different from the value of the asset shown
in its financial statements, it has made a capital gain (or loss). This realised capital gain
(or loss) is added to (subtracted from) the companys operating profit. Realised capital
gains from the companys sale of assets (net of losses) are subject to capital gains tax,
which, for companies, is levied at the corporation tax rate. The details for calculating
corporation tax and capital gains tax were given in Chapter 3 (Section 3).

2.10 Other comprehensive income
This account was introduced in J anuary 2009. It includes income and expenses that are
not recognised in profit or loss and yet help to give a comprehensive picture of the
income of the organisation.

Some adjustments to book values go directly to equity balances other than
retained earnings. For example, a gain on the revaluation of property will go to
the revaluation reserve. Any such gains are not shown in the income statement,
but they are shown in the statement of other comprehensive income. The total
for other comprehensive income reflects increases in shareholder wealth,
whether arising from profit or from the recognition of some other gain.

Other comprehensive income includes:
the change in the revaluation reserve arising from the revaluation of property,
plant, equipment and intangible assets
the change in the fair value of available-for-sale financial assets and investments
the gains/losses from translating financial statements of a foreign operation
(currency translation differences)
actuarial gains/losses on defined benefit pension schemes
losses/gains on cashflow hedges
tax relating to components of other financial income.

Tescos Annual Report and Financial Statements, 2011, include most of these items in
other comprehensive income.
Page 18 CT2-08: The main accounts

The totals are carried forward to the reserves (and hence to the statement of financial
position) and are also shown in the statement of changes in equity.

The most likely item that you will have to deal with is the first in the list.

Revaluation

Revaluation of non-current assets (such as land and property) is the practice of
recording non-current assets at market or fair value. For example, a building could be
revalued at 2m (from 1m), so the value of the companys assets in the statement of
financial position increases by 1m. How is this treated in the financial statements?

If the asset is used in the companys business:
the revaluation reserve (in the equity section of the statement of financial
position) is increased by 1m and so the balance sheet remains balanced
there is no impact on the income statement
the 1m would also be shown as a gain on revaluation in the other
comprehensive income section at the bottom of the statement of comprehensive
income.

The treatment of unrealised gains on assets held as investments is more complicated,
but, fortunately, beyond the requirements of the syllabus.

What if the revaluation is downwards rather than upwards?

If the asset is used in the companys business, then any downward revaluation is
charged as an expense in the income statement unless it reverses a previous upward
revaluation, in which case it is charged against the revaluation surplus for that asset.


Question 8.6
The following data relates to Zip plc for the trading year ending 31st December 2010.

000s
Advertising expenses 50
Revenue 1,135
Stock at 31st December 2009 25
Interest paid 14
Interest received 5
Depreciation of machinery 25
Stock at 31st December 2010 38
Wages and salaries of production staff 161
Wages and salaries of distribution staff 278
Wages and salaries of administration staff 40
Purchases 300
Directors remuneration 135
Dividends paid in respect of year ending 31 December 2009 30

Produce the companys statement of comprehensive income for the year, assuming:
corporation tax is 24%
the company proposes a payout ratio of a third, ie to distribute a third of this
years earnings to shareholders
the number of ordinary shares in the company is 200,000
at the end of the year, the companys property was revalued at 525,000, an
increase of 22,000 from its previous value.

3 The cashflow statement
The cashflow statement is not a requirement of the UK Companies Act. However it is a
Financial Reporting Standard (FRS 1) and an International Accounting Standard
(IAS 7) and has been since 1992.

3.1 Why is the cashflow statement needed?
To show cash movements

The cashflow statement is intended to supplement the income statement and
statement of financial position. These are useful statements in their own right.
They do not, however, provide a sufficient insight into movements in cash
balances. This is unfortunate because even profitable companies will collapse if
they are not sufficiently liquid.

The bank balance is, of course, disclosed in the statement of financial position.
It is easy to see whether the balance has changed since the end of the previous
year. It is, however, difficult to identify the major causes of such changes.
Shareholders and other readers require a more structured description of the
cashflows.

The cashflow statement is intended to answer the following types of question:
Why has the bank overdraft increased, despite the company having had a
profitable year?
Is the company capable of generating cash, as opposed to profit, from its
trading activities?
What was done with the loan which was taken out during the year?

Cashflow statements show where the money has come from, and where it has gone.
They ignore the accruals concept.

Cash is important

Very few businesses could survive a prolonged cash outflow. It is often this
rather than lack of profits which causes companies to file for bankruptcy.


Cash may also be important for the opposite reason. Because most companies ought to
be able to earn a higher rate of return on their assets than on cash, a company that
passively holds large amounts of cash may not be making the best use of its resources.
So, a clear statement of a companys cashflow position allows shareholders to check
whether the company is being run efficiently (ie not holding too much cash) as well as
checking on solvency (ie holding too little cash). Cashflow statements help focus on
the changes in a companys holdings of cash.

Cashflows are important, but only because the entity needs cash to survive. The
main reason for being in business is to earn a profit.

Cashflows should be monitored to ensure that, say, expansion of the business
does not force it into a cash deficit, but a strong cash inflow is not an end in
itself. If a business has too much cash then it may actually be desirable to put
that money to some good use by investing in productive assets or even by
repaying loans. If there are no such opportunities then it may even make sense
to make a sizeable payment to the shareholders as a dividend or the repurchase
of shares.

Profit is not the same as cash

The profit figure for the year is unlikely to bear any resemblance to the increase
or decrease in the companys bank balance or total for working capital over that
period. Several entries in the income statement, such as depreciation, do not
involve funds. Furthermore, the income statement recognises credit sales and
purchases before any cash changes hands. Conversely, many receipts and
payments, such as the proceeds of share issues and loan repayments, have no
immediate impact on profit. It is possible for a company to trade profitably and
still run into liquidity problems.

A company can be very successful and profitable in terms of the income statement, yet
not be able to find enough cash to finance its day-to-day activities. The company could
be selling its goods in large quantities but building up large amounts of trade
receivables (debtors) and overdrafts as the company pays its suppliers and its other
expenses but its customers are slow to pay their bills.

The increase in a companys cash holdings will differ from the accounting profits
shown in the income statement. The main reason for this difference is the application of
the accruals principle.


Question 8.7
Give an example of how the accruals concept can cause the cashflow statement and the
income statement to differ from one another.

Question 8.8
State the immediate effect of each of the following events on a companys pre-tax
accounting profit and on its holdings of cash:

(a) the purchase of a non-current asset for cash
(b) selling goods on credit at a price above cost
(c) purchasing raw materials on credit at a price above their realisable value
(d) increasing the depreciation charge
(e) an upward revaluation of inventories held
(f) the issue of loan capital or new shares for cash
(g) selling an investment (capital gain =0)
(h) being assessed for, and paying tax
(i) paying dividends
(j) paying a creditor.

Less subjective nature of cashflow statement

The preparation of a cashflow statement is open to less interpretation than the
preparation of the income statement. For example:

1. profits in an income statement can be distorted if adjustments are made
directly to the statement of financial position, without a corresponding entry in
the income statement.

2. in determining profits subjective judgements are often needed, eg
how much provision should be made for bad debts?
which method of depreciation should be used?
how should we value stocks?
how should we interpret the accruals concept?


In contrast, there is much less interpretation involved in preparing a statement of
cashflows. Either you have spent the cash or you havent.

Question 8.9
Explain in detail how and why the following items can be interpreted in different ways
when companies report their profits.

(i) valuation of inventories (stocks)

(ii) assessment of depreciation.


3.2 The structure of a cashflow statement
There are three sections to the cashflow statement:
cashflows from operating activities - starting from operating profit and
reconciling operating profit to cash
cashflows from investing activities - acquisitions and disposals of long-term
assets and other investments not included in cash equivalents
cashflows from financing activities - changes in the size of equity capital and
borrowings.

The following is an example of a cashflow statement:

000s
Cashflows from operating activities
Cash generated from operations 33,100
Interest paid (9,200)
Tax paid (14,500)
Net cash generated from operating activities 9,400

Cashflows from investing activities
Purchases of property, plant and equipment (9,800)
Proceeds from sale of property, plant and equipment 6,400
Purchases of intangible assets (3,000)
Loans granted to related parties (1,300)
Loan repayments received from related parties 100
Interest received 1,200
Net cash used in investing activities (6,400)

Cashflows from financing activities
Proceeds from issuance of ordinary shares 1,000
Proceeds from borrowings 8,500
Repayments of borrowings (10,000)
Dividends paid to companys shareholders (11,000)
Net cash used in financing activities (11,500)

Net (decrease)/increase in cash, cash equivalents and bank
overdrafts
(8,500)
Cash, cash equivalents and bank overdrafts at beginning of the year

30,000
Cash, cash equivalents and bank overdrafts at end of the year 21,500


The details of the calculation of cash generated from operations would normally be
shown as a note. (See next section.)

We will look at the three sections of the statement in turn.

Net cash generated from operations

This shows that the company generated cash inflows of 9.4m from its trading
activities.

The starting point for this figure is the operating profit from the income statement.
Various adjustments have to be made in order to find the cash generated from operating
activities.

The cash generated from operations is determined as:

Operating profit 33,000
Adjustments for:
Depreciation 18,000
Changes in working capital:
Inventories (7,000)
Trade and other receivables (1,500)
Trade and other payables (9,400)

The operating profit figure in the income statement includes an accounting
adjustment in respect of depreciation. The cashflow related to that expense
occurred when the non-current assets were purchased.

Depreciation has been added back in to the operating profit before calculating the cash
generated from operating activities because depreciation is not a cash item.

The companys trading activities also include transactions involving inventories
(stock), trade receivables (debtors) and trade payables (creditors). These can
affect cashflows without affecting profits. If, for example, the company received
100 from its debtors at the start of the year, made sales of 1,000 during the
year and was owed 150 at the year end it would have received cash from its
debtors of 100 + 1,000 150 = 950. Thus, it would report income of 1,000
even though cash takings were less because some of the sales had resulted in
an increase in debtors rather than an inflow of cash.

Two more deductions must be made - interest paid and tax paid - in order to arrive at
net cash generated from operating activities.


The other headings on the statement deal with cashflows which arise from non-
trading activities: investing activities and financing activities.

Investing activities

These can include the following:
purchase and sale of non-current assets, property, plant and equipment
plus intangible assets, like patents
receipts of interest and dividends from investments
transactions involving liquid assets other than cash, such as short-term
investments in securities.

Financing activities

These can include the following:
payment of dividends to the companys shareholders
cashflows arising from the repayment of loans and from fresh borrowing
and the issue of shares.

The cashflows are classified according to the broad headings of operating
activities, investing activities and financing activities. The boundaries of those
classifications are not that clearly defined (for example, the payment of tax can
be shown under any of the three headings). It is, however, possible to see how
the net cash inflow or outflow for the year is broken down into categories such
as:
cash received from customers and paid to suppliers (operating)
cash applied by purchasing property, plant and equipment and raised
from its disposal (investing)
cash raised from borrowing and issuing shares and applied to
repayments and repurchases (financing).

Note that the syllabus requires an understanding and ability to interpret cashflow
statements; you are not required to construct them. However, it is worth constructing a
few so that you can understand them well.

The key to interpreting a cashflow statement is to look at the financial position
both before and after the period. The cashflow statement is a useful means of
determining whether the cash balances have increased or decreased and
explaining those movements. It is impossible to tell whether that increase or
decrease was desirable without considering the closing balances to check that
the financial position is solvent.


Question 8.10
Using the information given below, draw up LoadsaMoneys cashflow statement for
2011 and comment on the cash movements and the final cash position.

During 2011, LoadsaMoney had the following items of income and expenditure:

increase in stocks of finished goods 13,500
staff cost 47,300
income from WaddsaCash dividends 4,200
turnover 362,000
tax paid 49,120
dividends paid 15,000
increase in work-in-progress 2,100
interest received on 3-month bank deposit 3,500
interest paid on loan stock 5,500
2011 sales for which payment not yet received 71,000
payments for 2010 sales received in 2011 63,000
2011 raw material purchases not yet paid for 37,000
2010 purchases paid for in 2011 40,000

The company bought 3 bank note printing machines in J anuary 2011 for 35,000 each.
The total depreciation charge for 2011 was 22,450.

On 1 J anuary 2011, the company had 50,000 in cash and 98,000 in a three-month
bank deposit. By 31 December 2011, it had a 73,780 in cash and 95,000 in three-
month bank deposit.

LoadsaMoneys operating profit for 2011 was 191,850.


4 Statement of changes in equity
A further requirement of the international standards is a statement of changes in
equity. This summarises the changes in the capital and reserves attributable to
equity holders of the company over the accounting period, and so reconciles the
amounts shown in the statement of financial position at the start and end of the
period.

An example for a one-year period is given below:

Attributable to equity holders of the
company
000
Share
capital
Other
reserves
Retained
earnings
Total
equity
Balance at 1 January 20X1 30,000 10,000 15,000 55,000
Fair value gains and (losses), net
of tax:

Land and buildings 2,000 2,000
Depreciation transfer,
land and buildings
(750)

(750)
Net income/(expense) recognised
directly in equity
1,250 1,250
Profit for the year 5,000 5,000
Total recognised income for 20X1 1,250 5,000 6,250

Dividends paid (3,000) (3,000)

Issue of share capital 10,000 10,000

Balance at 31 December 20X1 40,000 11,250 17,000 68,250

Notice the revaluation of land and buildings is recognised in the other reserves.

4.1 Dividends paid
The final earnings for the year may be used to pay dividends. It would be unusual for
the company to distribute all of the profit in this way. The remainder is retained
within the business as part of the owners equity and transferred to the retained earnings
part of the statement of financial position.

The amount of dividend being proposed to the shareholders is included in the draft
accounts presented for the approval of shareholders at the Annual General Meeting.

Once the dividends are approved at the AGM, an approved set of accounts can be
drawn up.

When dividends are paid they appear as a note beneath the income statement and will
be deducted from the cash balance and from the retained earnings in the equity section
of the statement of financial position as shown in the statement of changes in equity.
They will also show up in the cashflow statement and in the notes to the accounts.

Question 8.11
Produce a statement of changes in equity for 2011 for Planet plc, given the following
equity sections of the statements of financial position for 31 December 2010 and
31 December 2011 plus notes.

31 December 2010 31 December 2011
000s 000s
Share capital (50p shares) 800 Share capital (50p shares) 1,000
Other reserves 200 Other reserves 400
Retained earnings 500 Retained earnings 600
Total equity 1,500 Total equity 2,000

Notes:
1. During the year, 400,000 new shares were issued @75p.
2. On 30 J une 2011, the companys land was revalued. Its book value at the time
was 500,000. This increased to 600,000 at fair value. This increase is
recognised in the revaluation reserve. There has been no depreciation since the
revaluation.
3. The profit after tax for 2011 was 120,000.
4. Dividends for 2010 of 20,000 were paid during 2011.


5 Notes to the accounts
As noted in Chapter 7, UK legislation requires companies to produce accounts
which include detailed disclosures appropriate explanatory notes and
additional information. These are normally presented as a series of notes to the
accounts.

The notes will cover:
details of the accounting policies used in preparation of the financial
statements
detailed analysis of totals shown in the statement of financial position
detailed analysis of income statement items
details of post-balance sheet events.

In addition, companies will normally disclose, voluntarily, additional information
designed to help the readers of the accounts to gain a true and fair view of the
position of the company.

In the past, this area of the course has been examined by a variety of questions.
Multiple-choice questions have often been used to test definitions and classifications.
Short questions have sometimes been asked about the difference between profit and
cash. Long (20-mark) questions have often been asked on the construction of income
statements and statements of financial position. Candidates have usually been given
information drawn from a trial balance (see Chapter 10) and asked to construct
particular accounts.


Solution 8.5
The cost of sales is only the cost of stock sold. This is found as follows:

Opening stock 2,000
+Purchases 20,000
Closing stocks (7,000)
Cost of sales 15,000


Solution 8.6
Statement of comprehensive income for Zip plc for the year ending 31st Dec 2010

000s
Revenue 1,135
Cost of sales
Cost of stock sold:
Opening stock 25
Purchases 300
less Closing stock (38) 287
Wages and salaries of production staff 161
Depreciation of machinery 25 (473)
Gross profit 662
Distribution costs:
Advertising expenses 50
Wages of distribution staff 278 328
Administrative expenses:
Wages of administrative staff 40
Directors remuneration 135 175 (503)
Operating profit 159
Finance income 5
Finance cost (14)
Net profit before tax 150
Tax expense (36)
Profit after tax 114
Other comprehensive income
Gains on revaluation 22
Total comprehensive income 136
Earnings per share for profit attributable to
equity holders
57p

Notes to the accounts:

1. The companys property was revalued and increased in value by 22,000.
2. A dividend of 30,000, ie 15p per ordinary share, was paid during the year in
respect of the year ending 31 December 2009.
3. The company proposes to make a dividend payment of 38,000, ie 19p per
ordinary share, in respect of the year ending 31 December 2010.

Solution 8.7
The following is only one of a number of possible examples.

Let us assume that a company pays a fee of $10 million to a marketing company to
advertise its product over the coming 12 months. Let us also assume that the
companys accounting year runs from 1st J anuary to 31st December, and that the date
of the deal is 1st J uly.

The payment of the fee is clearly a distribution cost and should be shown as such in the
income statement. The payment of the fee would have an immediate cashflow effect
which would fall into the cashflow statement in the current financial year. However, by
the accruals principle, the expense should be recognised over the period of the contract,
ie over the period which the company expects to benefit from the expenditure. It will
therefore be accrued over the coming 12 months, and $5 million will fall into this years
income statement and $5 million into the next financial year.

So cash will fall by $10 million, but the income statement for the year will show an
expense of $5 million.


Solution 8.8
Event Pre-tax profits Cash
a the purchase of a non-current asset for cash No change Reduced
b selling goods on credit Higher No change
c purchasing raw materials on credit Lower No change
d increasing the depreciation charge Lower No change
e an upward revaluation of inventories held Higher No change
f issue of loan capital or new shares for cash No change Higher
g selling an investment (capital gain =0) No change Higher
h being assessed for, and paying tax No change Lower
i paying dividends No change Lower
j paying a creditor No change Lower

Comment: cash and profits are not the same!


Solution 8.9
The main problem is that profits are directly influenced by the value placed on
inventories (stocks) and depreciation, yet the assessment of these is, to an extent,
subjective.

(i) Valuation of inventories (stocks)

Increase in inventories is included within a companys income statement, so a
large increase in inventories over a particular year may lead to an increase in
profits even though sales revenue has not increased.

If inventories are valued on a FIFO basis, their value will increase with inflation.
The distortion mentioned above will be enhanced by this factor.

Note: A FIFO basis indicates the method by which a company calculates its cost
of materials. If a certain amount of stock is disposed of as a result of selling the
companys product, then the company can either take the cost of that stock as
being the cost of the most recently purchased stock (Last In First Out) or the
cost of the oldest stock (First In First Out). Best accounting practice suggests
the use of FIFO.

Does the method of inventory valuation really give a true and realisable value of
the inventories held at any one point in time? If it does not, then any figure for
increase in inventories shown in an income statement may be questionable.

(ii) Assessment of depreciation

The assumptions made about an asset may not be true to life, eg a lorry with an
expected useful life of ten years may, in reality, need to be replaced after seven
years. The depreciation charge during the 7 years would then not reflect the true
cost of using the asset.

The method of calculation may not be appropriate to the asset. For example,
many companies use the straight line method of depreciation for their vehicles
because they would expect the vehicles to be used at a reasonably constant rate.
However, as any car owner will know, this type of depreciation is not
necessarily the most appropriate. A new car can depreciate fastest during the
first 5 minutes after its purchase.


Solution 8.10
Cashflow statement for LoadsaMoney 2011

Cash generated from operations * 187,700
Interest paid (5,500)
Tax paid (49,120)
Net cash generated from operating activities 133,080
Purchases of machinery (105,000)
Interest received 3,500
Dividends received 4,200
Equity dividends paid (15,000)
Net cash used in financing activities (15,000)

Net increase in cash/cash equivalents and bank overdrafts 20,780
Cash/cash equivalents and bank overdrafts at beginning of the year 148,000
Cash/cash equivalents and bank overdrafts at end of the year 168,780

* Cash generated from operations is:
Operating profit 191,850
plus Depreciation 22,450
less Increase in inventories (stocks) (13,500 +2,100) (15,600)
less Increase in trade receivables (debtors) (71,000 - 63,000) (8,000)
less Decrease in trade payables (creditors) (37,000 - 40,000) (3,000)


Comments:

The cash balance has increased by 20,780 from 148,000 to 168,780 (an
increase of 23,780 in cash and a decrease of 3,000 in a three-month bank
deposit). We do not know whether this is a reasonable cash position because
we do not have sufficient information about the companys other assets and its
liabilities. However, it seems high in relation to the companys annual turnover
of 362,000.

It seems strange that the company has increased the amount held in cash and
decreased the amount held on three-month deposit, since the latter earned
interest of 3,500 in 2011.

The company has generated 133,080 from its operating activities; and has spent
97,300 on investing activities and 15,000 on its financing activities. The
company is in the fortunate position of being able to finance new investment
(the purchase of the printing machines) with the cash generated from just one
years operating activities! To generate cash overall in a year of self-financed
high investment is relatively unusual.

The key to the companys healthy cash position is its operating profit of
191,850, which translates into a cash contribution of 133,080. During the
year, it has used cash in building up stock and work-in-progress, increasing its
trade receivables and decreasing its trade payables. Although not causing a cash
problem this year, the company should check that its stock levels are not
unreasonably high, that its credit terms for customers are not unreasonably
generous, and that it is making the best use of available credit from suppliers.

The companys net profit before tax and interest is 199,550 (191,850 +3,500
+4,200). As a percentage of its turnover, this is 55%, so this company seems
to be well-named it is both profitable and cash-rich!

The company paid 5,500 in interest on loan stock. In future years, if its cash
position continues to be as favourable, it might not need to take out any new
loans and will therefore save the interest payments.

The company paid 49,120 in tax. This represents about 25% of the companys
net profit before tax and interest.


The company has earned relatively little from investing in activities outside the
business. In future years, it would seem to make sense to expand the business,
but if further growth is unlikely, it could consider investing in a range of
financial assets. Alternatively, it could reward the shareholders with more
generous dividends or by buying back some shares.

Solution 8.11
Statement of changes in equity for 2011

Attributable to equity holders 000s
Share
capital
Other
reserves
Retained
earnings
Total
equity
Balance at 31 December 2010 800 200 500 1,500
Fair value gains on land and
buildings
100 100
Profit for 2011 120 120
Total recognised income for 2011 100 120 220
Dividends paid (20) (20)
Issue of share capital during 2011 200 100 300
Balance at 31 December 2011 1,000 400 600 2,000

CT2-14: Financial institutions Page 13

Settlement for gilts

Gilt transactions have to be settled the day after the deal is made. In comparison
to equity settlement, this is so astonishingly quick that the Stock Exchange refers to it as
cash settlement.

Buyers and sellers deal directly with each other, rather than through a third
party.

Providing investors with information

The Stock Exchange also publishes information which may be of interest to
investors. Much information can be accessed via its website
http://www.londonstockexchange.com.

The Stock Exchange Daily Official List (SEDOL) shows details such as price and
volume of transactions in all the securities listed on the Stock Exchange. It is
prices in the official list that HM Revenue and Customs recognises when
calculating capital gains.

Question 14.4
What are:
(i) GEMMs
(ii) SEAQ
(iii) CREST
(iv) SEDOL

Question 14.5
Give the four main roles of the Stock Exchange.

Page 14 CT2-14: Financial institutions

3 The derivatives exchanges
Derivative contracts, which draw their value from that of an underlying asset
(eg coffee), security (eg BP shares) or an index (eg FTSE 100), are primarily used
to hedge risks, or for speculation.

Derivative contracts are traded either directly between two parties, called Over-
The-Counter (OTC contracts), or are traded via an exchange, such as NYSE Liffe,
and are called exchange-traded contracts.

Derivatives exchanges provide an efficient, transparent and orderly trading environment
for trading in derivatives.

NYSE Liffe, is Europes largest exchange by value of business traded, bringing together
the five European derivatives markets of Amsterdam, Brussels, Lisbon, London and
Paris. It is a market for a variety of derivatives products including interest rates, bonds,
equities, indices, commodities and swaps, and it trades $2,900 billion every day thats
$40 million a second!


4.6 Open-ended investment companies (OEICs)
Open-ended investment companies (OEICS) have characteristics of both
investment trusts (they are companies with a single share price) and unit trusts
(new shares are created when money is invested, with the price reflecting the net
asset value of the fund).

Like investment trusts, OEICs are companies that issue shares on the London Stock
Exchange, and that use the money raised from shareholders to invest in other
companies. Like unit trusts, they are open-ended which means that when demand for
the shares rises the manager just issues more shares. With an investment trust, if
demand exceeds supply, the response may be a rise in the share price. The price of
OEIC shares is determined like a unit trust, with the key factor being the value of the
underlying assets of the fund. But in contrast to unit trusts, there is no bid/offer spread
with OEICs, so the price of the shares should be the same whether you are buying or
selling. OEICs have been popular on the continent but were only launched in the UK in
1997. Many unit trusts have switched to become OEICs.

OEICS are the preferred legal form over unit trusts for new open-ended
investment vehicles.

Question 14.10
Complete the following sentences by adding the correct beginning:
... is a closed end fund
... are determined by the market
... may have specific investment objectives
... may borrow by means of equity and debt capital
... is regulated by trust law
... are determined using bid and offer pricing
... may have a set winding-up date.
Possible beginnings:
Unit prices ...
A unit trust ...
Prices of shares in an investment trust ...
An investment trust ...
Both unit trusts and investment trusts ...

4.7 Investment management companies
Investment management companies (often referred to as fund managers)
perform a range of activities centred around the core service of investing client
assets:
front office functions (buying and selling investments, formulating
stock selection and asset allocation decisions, research, cash
management)
back office functions (including custody, transaction processing and
settlement, stocklending).

Firms are increasingly unbundling some of these services and outsourcing an
increasing number of functions, in order to focus on the core service of
investment.

Role in investment markets

As noted above, investment management companies are primarily involved in
buying and selling investments and formulating stock selection and asset
allocation decisions. In many countries, investment management companies
handle immense volumes of assets. The industry is also, typically, very
concentrated with a small number of firms dominating the market. Short-term
fund performance is often a key factor in attracting and retaining clients.

UK institutional investors own more than half of the quoted equities. The principal
institutional investors are occupational pension funds and life insurance companies.
Most occupational pension schemes are organised on a trust basis, with a board of
trustees responsible for the determination of asset allocation. Since many trustees lack
the necessary expertise, most trusts use investment consultants and employ fund
managers.

The investment consulting industry in the UK is small and highly concentrated. The
fund management industry in the UK is huge, managing assets of over 2,500bn, for
domestic and overseas clients, in the year 2000. Recently, the trend has been for
pension funds to switch from using a single fund manager to using a number of
specialist fund managers for different classes of assets. This has enabled smaller firms
to specialise and to co-exist with the larger firms. However in the year 2000, 80% of
UK pension assets were controlled by the top 15 pension management firms.


Chapter 14 Summary

The Bank of England is the UKs central bank. Its main functions are:
executing monetary policy on behalf of the government, ie controlling interest
rates and the money supply
providing the liquidity needed by the banking system and acting as the lender
of last resort
maintaining the UKs foreign reserves, and using these to influence exchange
rates
acting as the bankers bank
settlement of trades

The Debt Management Office has responsibility for managing the national debt and
selling/buying back Treasury bills and gilts for the government.

The Stock Exchange has two key roles:
raising new finance for companies and governments
providing a secondary market for investors

The Stock Exchange provides a market for the trading of securities. It regulates that
market and provides procedures for the settlement of trades carried out in the market. It
also provides investors with information.

Derivatives exchanges provide markets for derivative products such as futures and
options.

Investment banks perform a wide variety of roles including giving advice to companies
and helping companies raise finance.

Clearing banks channel the private sectors excess short-term cash to private sector and
institutional borrowers.

Building societies channel private individuals excess short-term cash to private
individuals who need to borrow to buy a house.

Investment trusts are companies whose business it is to invest money. Some investment
trusts have a set winding-up date. Their capital structure may be split between capital
shares and income shares.

Unit trusts are regulated by trust law. They are not companies. They channel investors
money into the UK and overseas stock markets. Unit trusts and investment trusts may
have specified investment objectives. They provide an opportunity for small investors
to own a share of a big, well diversified and professionally managed portfolio.

Open-ended investment trusts have characteristics of both investment trusts (they are
companies with a single share price) and unit trusts (new shares are created when
money is invested, with the price reflecting the net asset value of the fund).

Investment management companies (or fund managers) perform a range of services for
their clients. The main ones are buying and selling assets and formulating stock
selection and asset allocation decisions.

A self-administered pension scheme is one that is responsible for its own investment
strategy. It does not hold an insurance companys contract as its sole asset.
Collectively, pension schemes are the most important investors in the UK gilt and
equity markets.

Life insurance companies pool mortality and investment risks by writing long-term
policies. They also channel savings into the long-term capital markets.

General insurance companies write short-term policies to cover a variety of (non-life)
risks. They sell a lot of policies to cover risks in overseas countries.


At a glance summary of financial institutions

Institution Investment banks Clearing banks Building societies Pension schemes
Role Advise companies and help
companies raise finance.
Channel private sectors excess
short-termcash to private sector and
institutional borrowers.
Channel private individuals
excess short-term cash to private
individuals to borrow to buy a
house.
Channel savings for retirement into
the long-term capital markets.
Source of funds Receive fees for advice,
underwriting commission, fund
management, Eurobond dealing,
trusteeship, and bill acceptance.
Borrow money by running banking
accounts and issuing certificates of
deposit.
Deposits by private individuals and
by companies.
Borrow from other banks when they
are short of cash.
Deposits from private individuals
with a small, but increasing, amount
from the money and bond markets.
Contributions from employers and
employees only.
No borrowings.
Application of funds Invest in bills and provide loans and
leases to companies.
Grant loans and overdrafts to
customers.
Surplus cash invested in other banks
(using certificates of deposit), short-
dated gilts and local authority
bonds, bills of exchange and
Treasury bills.
Grant house-purchase mortgages
and some personal loans.
Surplus cash is invested in short-
dated gilts and local authority
bonds, other banks and building
societies (using certificates of
deposit).
Typical fund invests in UK
equities and longer-dated gilts and
company debt. Also some
investment in overseas securities.
Small proportion of the assets
invested in property, money
market investments and index-
linked gilts.


At a glance summary of financial institutions

Institution Investment trusts Unit trusts Open-ended investment
companies
Life insurance companies General insurance
companies
Role Pooled investment vehicle,
channels investors money
into the Stock Market and
other (mainly long-term)
assets.
Pooled investment vehicle
which channels investors
money into the UK and
overseas stock markets.
Pooled investment vehicle,
channels investors money
into the Stock Market and
other (mainly long-term)
assets.
Pool mortality and
investment risks by
channelling savings into the
long-term capital markets.
Provide cover by pooling
a variety of risks.
Source of funds Private individuals and some
institutions buy shares.
Also raise debt finance.
Private individuals and some
institutions buy units. Unit
trusts do not borrow.
Private individuals and some
institutions buy shares.
Also raise debt finance.
Premiumincome from
policyholders.
Do not usually borrow money.
Premiumincome from
policyholders.
Do not borrow money.
Application of funds Invest mainly in the longer-
termmarkets: UK equities,
UK gilts and other fixed
interest, overseas equities,
property.
Most unit trusts invest mainly
in longer-term quoted
securities: UK equities,
interest, and overseas equities.
Invest mainly in the longer-
termmarkets: UK equities,
interest, overseas equities,
property.
Typical fund invests in a
mixture of UK equities and
fixed interest securities.
May have some investment in
overseas securities, property,
money market investments
and index-linked gilts.
Typical insurer invests in
short-dated fixed interest
and money market
investments.
May also invest quite
large amounts in UK
equities and overseas
securities (to back non-
sterling policies)

CT2: Q&A Bank Part 3 Questions Page 19
Question 3.31
Using the following financial information to calculate appropriate ratios, comment on
Light Fantastic UKs sources and uses of cash over the year. [10]

Statements of financial position for Light Fantastic UK at 31st December 2010 and
31st December 2011

2010
2011
Assets 000 000
Non-current assets
Non-current assets (at original cost) 302 344
Depreciation to date (86) (110)
Current assets
Inventories 41 35
Trade receivables 21 25
Cash 43 45
Total assets 321 339

Equity and liabilities
Share capital (25p ordinary shares) 45 50
Share premium account 21 24
Retained earnings 96 110
Total equity 162 184

Non-current liabilities
Loan stock 140 130
Current liabilities
Trade payables 7 17
Tax payable 12 8
Total liabilities 159 155
Total equity and liabilities 321 339

Notes:
1. Depreciation for the year amounted to 28,000.
2. New machinery was bought during 2011 for 50,000.
3. A machine was sold at its book value of 4,000 during the year.
4. Dividends for 2010 of 12,000 were paid.

Page 20 CT2: Q&A Bank Part 3 Questions
Items from the income statement for the year ending 31st December 2011

000
Sales revenue 251
Operating profit 47
Finance costs 10
Profit before tax 37
Corporation tax 11
Profit after tax 26

The cashflow statement for Light Fantastic UK for the year 2011

(000s)
Cash generated from operations
1
87
Interest paid (10)
Tax paid (15)
Net cash generated from operating activities 62

Purchase of machine (50)
Sale of machine 4
Net cash used in investing activities (46)

Proceeds from share issue 8
Repayment of loan (10)
Dividends paid (12)
Net cash used in financing activities (14)

Net increase in cash, cash equivalents and bank overdrafts 2
Cash, cash equivalents and bank overdrafts at beginning of the year 43
Cash, cash equivalents and bank overdrafts at end of the year 45
Notes
1. Cashflows from operations:
Operating profit 47
plus depreciation 28
plus decrease in inventories 6
less increase in trade receivables (4)
plus increase in trade payables 10
87
CT2: Q&A Bank Part 3 Solutions Page 29
Solution 3.31
Operating activities
- 62,000 has been generated from operating activities. []
- Inventory levels have decreased, which has generated free cash. []
- The stock turnover period is now 51 days
35
365
251
| |
|
\ .
. []
- Less time, space and cash is devoted to inventories, so this will improve the
efficiency of the business, as long as there is sufficient stock to meet the needs
of the customer. []
- There has been an increase in the amount of credit given to customers. []
- The debtors turnover period is now 36 days
25
365
251
| |
|
\ .
. []
- This use of cash might improve marketing and sales. On the other hand, the
company could suffer from bad debts. []
- The company has obtained more credit from its suppliers. []
- The creditors turnover period is now 25 days
17
365
251
| |
|
\ .
. []
- This gives the company more time to produce and sell its goods before it has to
pay its suppliers. However, this is still low compared with its debtor days. []
- Generally, liquidity is high. The current ratio has fallen from 5.5 in 2010 to 4.2
in 2011 and the quick ratio from 3.4 to 2.8 but these are still relatively high. [1]
- Interest of 10,000 has been paid. Interest cover is 4.7
47
10
| |
|
\ .
, so the companys
profit covers these payments reasonably well. [1]

Investing activities
- 46,000 has been used in investing activities. []
- The company has not made a profit or loss on the sale of a machine. []
- Since the companys liquidity position is sound, it could consider investing some
of its cash in liquid assets, eg in a three-month deposit, to earn some interest. []

Page 30 CT2: Q&A Bank Part 3 Solutions
Financing activities
- 14,000 has been used in financing activities. []
- The company has raised 8,000 in more equity finance and paid back 10,000 of
its debt. []
- As a result its gearing ratio has fallen from 46%
140
100
162 140
| |
|
+ \ .
to 41%
130
100
184 130
| |
|
+ \ .
. []
- This will reduce the volatility of the companys earnings and increase its asset
cover from 2.2
321 19
140
| |
|
\ .
to 2.4
339 25
130
| |
|
\ .
. []
- Dividends of 12,000 were paid. This is 6.6p per share
( )
12
45 0.25
. []
[Maximum 10]

CT2: Q&A Bank Part 5 Revision Questions Page 1
Part 5 Revision Questions

This part contains 100 marks of questions testing the material from the whole course.
You may like to try these questions under exam conditions as a mock exam.

Question 5.1
Which of the following might act as a lead underwriter in an issue of shares?

I an investment bank
II an investment trust
III an insurance company

A if I and II only are correct
B if II and III only are correct
C if I only is correct
D if III only is correct [2]

Question 5.2
Which of the following are NOT registered?

I shares
II commercial paper
III Eurobonds

A if I and II only are correct
B if II and III only are correct
C if I only is correct
D if III only is correct [2]

Page 2 CT2: Q&A Bank Part 5 Revision Questions
Question 5.3
An advantage of recourse factoring is that:

A the factor takes over all responsibility for credit analysis of new accounts.
B the factor must be a listed company.
C credit risk remains with the supplier.
D it provides early payment of invoices. [2]

Question 5.4
Company X based in the UK has an overseas subsidiary, which makes gross profits of
10m. These profits suffer 14% tax in the overseas territory. Assuming that the
corporation tax rate is 24% in the UK and that a double taxation agreement is in force
with the overseas territory, Company X will have to pay:

A no further tax on the 8.6m net profit.
B a further 10% tax on the 10m gross profits.
C a further 10% tax on the 8.6m net profits.
D a further 24% tax on the 8.6m net profits. [2]

Question 5.5
The accounts of HobHey plc show net profits before tax of 2m. The profit after tax
was 1.25m. The interest the company paid on its debenture was 0.25m. What is
HobHey plcs interest cover?

A 5
B 6
C 8
D 9 [2]

CT2: Assignment X1 Solutions Page 7
Information asymmetries often exist between various classes of stakeholder (managers,
workers, shareholders, debt holders etc), ie the different stakeholders have access to
different information. This makes any agency problem more difficult to resolve. It also
reinforces the need for proper accounting standards to be observed. [1]

A company is more expensive to establish and run than other forms of business. [1]
[Maximum 8]

Solution X1.13
Double taxation relief is intended to reduce the extent to which ...
... individuals and companies ... []
... are taxed twice on the same income. []

Double taxation relief is available on income and capital gains. [1]

Tax paid overseas on overseas income can be offset against the liability to domestic tax
on that income or capital gain. [1]

The maximum offset is the rate of tax that would have been paid locally on the grossed-
up income. [1]

For example, if a UK company has to pay 30% corporation tax and has paid 20% tax on
its profit made in India then it will have to pay the additional 10% in the UK. If it has
paid 40% tax on its profit in Norway, it pays no more tax in the UK. It cannot reclaim the
additional tax paid in Norway. [1]
[Maximum 4]

Page 8 CT2: Assignment X1 Solutions
Solution X1.14
Non-recourse factoring is where a supplier sells on its trade debts to a factor in order to
obtain cash payment of the accounts before their actual due date. The factor takes over
all responsibility for credit analysis of new accounts, payment collection and credit
losses. [1]

With recourse factoring, the supplier still receives a cash payment up front from the
factor, but the supplier retains responsibility for collecting the debt. Once the debt is
collected, the amount of the debt is paid over to the factor. [1]

Advantages of non-recourse factoring for Country Dairy Ltd:
The administration of debt collection would be undertaken by the factor. This
may be useful for a small business where there are few (if any) dedicated
accounts staff. []
Credit analysis would also be undertaken by factor. This may also be
particularly useful for a small business that would not have credit assessment
capabilities. []
The factor takes all of the credit risk. This would help make cashflow more
predictable. [1]

Advantages of recourse factoring for Country Dairy Ltd:
Recourse factoring would be cheaper than non-recourse factoring. If Country
Dairy Ltd is short of cash, it may be very price sensitive. [1]
All contact with customers will be through Country Dairy Ltd rather than the
factor. For a small business, maintaining amicable relations may be very
important. [1]
[Maximum 5]

Solution X1.15
A company which has tendered for a project will have used certain currency rates in its
calculations. If the currency rates move after the business has been won, then the
company may find that it is committed to a project which is no longer profitable at the
price tendered. []

The company will have to borrow in the overseas currency in order to finance the
project. It may use forwards and futures to ensure that the cost of buying the currency
is fixed at todays levels. []

CT2: Assignment X2 Questions Page 7

Cashflow statement for the year ending 31 July 2011

(000s)
Cash generated from operations
1
471
Interest paid (500)
Tax paid
2
(30)
Net cash used in operating activities (59)

Purchase of non-current assets (2,450)

Proceeds from borrowings
3
2,600
Dividends paid (50)
Net cash generated from financing activities 2,550

Net increase in cash, cash equivalents and bank overdrafts 41
Cash, cash equivalents and bank overdrafts at beginning of the year 13
Cash, cash equivalents and bank overdrafts at end of the year 54

Notes
1. Net profit + depreciation + increase in trade payables increase in trade
receivables increase in inventories
(800 +200 +(120 350) (240 51) (360 250))
2. Tax payable at start of year +tax in respect of 2011 tax payable at the end of
the year (30 +90 90)
3. Long-term debt has risen by 2.6 million.

Comment on any problems you uncover from an analysis of the companys cashflow
statement. [7]
[Total 14]

End of paper

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addition, we may seek to take disciplinary action through
the profession or through your employer.

These conditions remain in force after you have finished
using the course.
Statement of financial position as at 30 June 2011

ASSETS
Non-current assets 000s
Land and buildings
1
918.34
Plant & machinery
2
300.00
1,218.34
Current assets
Inventories 19.00
Trade receivables 90.00
109.00
Total assets 1,327.34

EQUITY AND LIABILITIES

Equity
Ordinary share capital 200.00
Share premium account 300.00
Retained earnings
3
145.34
Total equity 645.34

Non-current liabilities
Loan stock 600.00
Current liabilities
Bank overdraft 6.00
Trade payables 54.00
Tax 22.00
82.00
Total liabilities 682.00

Total equity and liabilities 1,327.34

Notes
1. Land and buildings =983 - 45 - 19.66 =918.34
2. Plant and machinery =550 - 150 - 100 =300
3. Retained earnings =180 50 +15.34 =145.34 [8]
[Total 15]

Solution X2.16
(i) Purpose of a cashflow statement

The main purpose of the cashflow statement is to show cash movements over a period of
time. []

A cashflow statement supplements the information contained in the statement of
financial position and the income statement. It is needed because these two statements
do not, on their own, provide sufficient information about the movement of cash
balances. []

Whereas the statement of financial position shows the amount of cash at the start and
end of each year, it does not show the causes of such changes. The cashflow statement
shows the sources and uses of the cash generated by the company during the year,
which is useful when assessing whether a company can continue in its present shape. [1]

Secondly, the cashflow statement shows the importance of cash. The cash figure is
important, though not an end in itself. []

If a company has too little cash, it could fail. Very few businesses could survive
a prolonged cash outflow. It is often this rather than lack of profits which causes
companies to file for bankruptcy. The cashflow statement will highlight the
source of these problems. [1]

On the other hand, if the company has too much cash, it is not making the best
use of its resources. The cashflow statement will help the company to consider
the reasons for the cash pile and to assess its options. [1]

It could invest in other productive assets and earn a better return than it can earn
on cash ... []

or, alternatively, it could repay a loan or reward the shareholders (with a large
dividend or an offer to buy back the shares). []

So, cashflows are important, but only because the entity needs cash to survive. The
main reason for being in business is to earn a profit. []

Thirdly, the cashflow statement highlights the differences between profit and cash. []

The income statement registers revenues and expenses before any cash is received or
paid, ie it is constructed using the realisation and accruals concepts. This can give a
very misleading description of a companys financial health. A company can be
profitable but insufficiently liquid. [1]
In addition, the income statement is not affected by some transactions such as
acquisitions and disposals of non-current assets and changes in loan and equity finance.
However, these transactions can have a major effect on the companys cash balances. [1]

Finally, the cashflow statement offers an objective statement of the companys cash
position, whereas both the income statement and the statement of financial position are
subjective statements, which can be manipulated by altering the accounting treatment of
particular items and transactions. The cashflow statement is not subject to such
manipulation. [1]
[Maximum 7]

(ii) Cashflow analysis

Initially, the company does look to be in a healthy cash position, as evidenced by
the fact that the cash balance has increased from 13,000 to 54,000. []

Breaking this down into the three constituents, the company has used 59,000 in
its operating activities; it has used 2,450,000 in its investing activities; and has
generated 2,550,000 from its financing activities. []

While it seems reasonable to finance investment, it seems less reasonable to
finance operating activities. []

The company has generated 471,000 from operations. During the year, it has
used cash in building up stock (by 44%), increasing its trade receivables (by a
huge 370%!) and decreasing its trade payables (by 66%). [1]

The company should check that its stock levels are not unreasonably high, that
its credit terms for customers are not unreasonably generous, and that it is
making the best use of available credit from suppliers. It could improve its
cashflow from operations by reducing the cash used in these three areas.
However, it must ensure that there is enough stock to cope with demand, that the
credit terms are sufficiently competitive to generate sales and that it maintains
good relations with suppliers. [1]

Perhaps stocks were increased in order to cope with greater demand and trade
receivables were increased as a consequence of greater demand (or perhaps to
generate greater demand) arising from the new investment. []

The major outflow of funds from operating activities is the interest paid on the
companys loans. In fact, at the current level of activities it cannot even finance
the current debt interest burden. []

We can also see that the profit of 800,000 is largely taken up with the 500,000
interest bill. This low cover of interest is risky because earnings could become
negative if profit were to fall. []

The company has preserved some cash by only paying tax due from previous
years. However it has a large outstanding tax liability remaining. []

The company has financed its investment entirely through increased borrowing
(an increase of 52%). The company now has a lot of debt finance relative to
equity finance (ie it is highly geared) which may lead to more expensive
borrowing in the future or force the company to reduce gearing by having a
rights issue. [1]

Borrowing can be risky because, as weve seen, the profits might not cover the
interest, and also because if the source of the borrowing dries up, this could lead
to the winding up of the company by the loan stockholders. []

Perhaps the new assets acquired have not as yet been used to full capacity. If
output, sales and profits increase in the following year, then both profit and
cashflow from operations should be better able to cover the interest payments. [1]

Finally, the company has used 50,000 to pay dividends to shareholders. []
[Maximum 7]

Assignment X4 Solutions

Answers to multiple-choice questions

The following table gives a summary of the answers to the multiple-choice questions.
The answers are repeated below with explanations.

1 C

6 D
2 C

7 C
3 D

8 C
4 C

9 B
5 A

10 C

Solution X4.1
Answer =C

The return on the share would be described by the following formula:

( )
5% 1.5 3% 5%
2%
i f i m f
r r r r

[2]

Solution X4.2
Answer =C

In a tax-free world, the following formula links the returns:

return on assets (return on debt) (return on equity)
D E
D E D E
= +
+ +

( ) 12% (0.25 6%) 0.75 return on equity = +

Thus: return on equity 14% =

Alternatively, we could calculate the return on equity directly as ( )
f g m f
r r r b + - .

We know that 12%
m
r = , 6%
f
r = . We also know that the assets of the company are
invested to give a market return. Therefore, we can say that the beta of the assets must
be 1 and
u
b , the ungeared beta, is also 1, since the beta of the assets is always the same
as the ungeared equity beta. So, if the company had no debt, the beta of the shares
would be 1. However, since there is debt, we adjust the beta according to the following
formula:

( ) ( )
25
1 1 1 1 1 0 1.333
75
g u
D
t
E
b b

= + - = + - =

So, the return on the geared shares is:

( ) 6% 1.333(12% 6%) 14%
f g m f
r r r b + - = + - = [2]

Solution X4.3
Answer =D

Modigliani and Millers first irrelevance proposition states that the market value of any
firm is independent of its capital structure so all of answers A to C are incorrect. [2]

Solution X4.4
Answer =C

The weighted average cost of capital (WACC) is found as follows:

D E
WACC net cost of debt cost of equity
D E D E
= +
+ +

We can find the net cost of debt as follows:

(1 )
=0.7 7% =4.9%
Net cost of debt t gross cost of debt = -

Subject CT2: CMP Upgrade 2012/2013

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The Actuarial Education Company IFE: 2013 Examinations

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