CT2-PU-13

CT2: CMP Upgrade 2012/13

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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.

The Actuarial Education Company

© IFE: 2013 Examinations

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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

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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 19  22) are provided at the end of this pack. Please keep your original page 22 for information on the dual aspect concept.



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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 17  30) 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.




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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 “FSA’s” with “regulator’s”. 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 13  14) are provided at the end of this pack. Please keep your original page 14 for information on investment banks.



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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 27  28) 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

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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 5  10) 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.”



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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: 4.


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. Replacement pages (pages 17  30) are provided at the end of this pack.




Page 9

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. (pages 35  42) are provided at the end of this pack.

Replacement pages

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.





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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 37  40) are provided at the end of this pack.




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Chapter 16 Page 17 In the box, please correct the figure for the increase in retained earnings. It should be £224,000.



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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”



Page 13

Solution 2.24 On page 13, replace Note 5 with the following: “5.

£12,825 from last year’s 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: “increase in cash

39,000”

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.”



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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 B C D

102 days 223 days 599 days 850 days

[2]”

Solution 3.4 The answer in unchanged. Please amend the calculation to read: “Average stock turnover period is: average inventory level 11,500 ¥ 365 = ¥ 365 = 600 days cost of sales 7, 000

[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.




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Question 3.31 A new question has been added to meet the new syllabus requirement. Replacement pages (pages 19  20) are provided at the end of this pack. Solution 3.31 Replacement pages (pages 29  30) are provided at the end of this pack.

Part 5 Question 5.3 This question has been changed. Replacement pages (pages 1  2) 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 1  2) 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.



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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 7  8) 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. [½]” 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 7  8) are provided at the end of this pack. Solution X2.16 The solution has changed. Replacement pages (pages 13  16) 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”.




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Assignment X4 Question 4.2 Towards the end of the first paragraph, please delete “the company’s 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 B C D

10.5%. 12%. 14%. 15.5%.

[2]”

Solution 4.2 The solution has changed and has been extended. Replacement pages (pages 1  2) 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”.



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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 ActEd’s 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 ActEd’s tutorials, please refer to our latest Tuition Bulletin, which is available from the ActEd website at www.ActEd.co.uk.




5.3

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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 ActEd’s marking services, please refer to the 2013 Student Brochure, which is available from the ActEd website at www.ActEd.co.uk.



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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 [email protected] or by fax to 01235 550085.



CT2-02: Company ownership

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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 Majesty’s Revenue and Customs (“HMRC”) can work out each partner’s liability to tax on their share of the partnership’s 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).



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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.

Legal and accounting documentation 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.




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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.)



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Legal and accounting documentation 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.




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Question 2.2 Draw up a table to compare a partnership, a limited liability partnership and a limited company with respect to:

1.5



main source of finance



legal identity



liability



documentation



disclosure



tax.

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 reregister 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.



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Private limited company All other limited companies are classed as private limited companies. A private limited company’s 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 company’s 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 member’s 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

5

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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 period’s 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.



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As you read each concept, don’t 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.




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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 company’s 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.



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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 company’s operating profit. Realised capital gains from the company’s 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 January 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.

Tesco’s Annual Report and Financial Statements, 2011, include most of these items in “other comprehensive income”.



Page 18


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 company’s 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 company’s 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 company’s 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.




Page 19

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 company’s 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 year’s earnings to shareholders



the number of ordinary shares in the company is 200,000



at the end of the year, the company’s property was revalued at £525,000, an increase of £22,000 from its previous value.



Page 20

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.




Page 21

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 company’s 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 company’s 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 company’s 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 company’s 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.



Page 22


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 company’s 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?




Page 23

In contrast, there is much less interpretation involved in preparing a statement of cashflows. Either you have spent the cash or you haven’t. 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.



Page 24

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 Interest paid Tax paid

33,100 (9,200) (14,500)

Net cash generated from operating activities

9,400

Cashflows from investing activities Purchases of property, plant and equipment Proceeds from sale of property, plant and equipment Purchases of intangible assets Loans granted to related parties Loan repayments received from related parties Interest received

(9,800) 6,400 (3,000) (1,300) 100 1,200

Net cash used in investing activities

(6,400)

Cashflows from financing activities Proceeds from issuance of ordinary shares Proceeds from borrowings Repayments of borrowings Dividends paid to company’s shareholders

1,000 8,500 (10,000) (11,000)

Net cash used in financing activities

(11,500)

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

(8,500)

Cash, cash equivalents and bank overdrafts at end of the year

21,500


30,000



Page 25

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 Adjustments for: Depreciation Changes in working capital:  Inventories  Trade and other receivables  Trade and other payables

33,000

(7,000) (1,500) (9,400)

Cash generated from operations

33,100

18,000

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 company’s 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.



Page 26


The other headings on the statement deal with cashflows which arise from nontrading 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 company’s 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.




Page 27

Question 8.10 Using the information given below, draw up LoadsaMoney’s 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

increase in cash

23,780

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 January 2011 for £35,000 each. The total depreciation charge for 2011 was £22,450. On 1 January 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 threemonth bank deposit. LoadsaMoney’s operating profit for 2011 was £191,850.



Page 28

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:

Balance at 1 January 20X1 Fair value gains and (losses), net of tax: Land and buildings Depreciation transfer, land and buildings

Attributable to equity holders of the company Share Other Retained capital reserves earnings 30,000 10,000 15,000

Net income/(expense) recognised directly in equity Profit for the year Total recognised income for 20X1

2,000

(750) 1,250

(750) 1,250

Dividends paid 10,000

Balance at 31 December 20X1

40,000

Total equity 55,000

2,000

1,250

Issue of share capital

£000

5,000 5,000

5,000 6,250

(3,000)

(3,000) 10,000

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.




Page 29

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 £000s Share capital (50p shares) 800 Other reserves 200 Retained earnings 500 Total equity 1,500

31 December 2011 Share capital (50p shares) Other reserves Retained earnings Total equity

£000s 1,000 400 600 2,000

Notes: 1.

During the year, 400,000 new shares were issued @75p.

2.

On 30 June 2011, the company’s 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.



Page 30

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.




Page 35

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



Page 36


Solution 8.6 Statement of comprehensive income for Zip plc for the year ending 31st Dec 2010 £000s 1,135

Revenue Cost of sales Cost of stock sold: Opening stock

25

Purchases

300

less Closing stock

(38)

Wages and salaries of production staff

287 161

Depreciation of machinery

25

(473) 662

Gross profit Distribution costs: Advertising expenses Wages of distribution staff

50 278

328

Administrative expenses: Wages of administrative staff Directors’ remuneration

40 135

175

(503)

Operating profit

159

Finance income

5

Finance cost Net profit before tax

(14) 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




Page 37

Notes to the accounts: 1.

The company’s 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 company’s accounting year runs from 1st January to 31st December, and that the date of the deal is 1st July. 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 year’s 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.



Page 38


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!




Page 39

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 company’s 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 company’s 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.



Page 40


Solution 8.10 Cashflow statement for LoadsaMoney 2011 £ Cashflows from operating activities Cash generated from operations *

187,700

Interest paid

(5,500)

Tax paid

(49,120)


133,080

Cashflows from investing activities Purchases of machinery

(105,000)

Interest received

3,500

Dividends received

4,200


(97,300)

Cashflows from financing activities Equity dividends paid

(15,000)


(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 22,450

plus Depreciation

(15,600)

less Increase in inventories (stocks)

(13,500 + 2,100)

less Increase in trade receivables (debtors)

(71,000 - 63,000)

(8,000)

less Decrease in trade payables (creditors)

(37,000 - 40,000)

(3,000)

Cash generated from operations


187,700



Page 41

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 company’s other assets and its liabilities. However, it seems high in relation to the company’s 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 year’s operating activities! To generate cash overall in a year of self-financed high investment is relatively unusual.



The key to the company’s 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 company’s 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 company’s net profit before tax and interest.



Page 42




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

Balance at 31 December 2010

Share capital

Other reserves

Retained earnings

Total equity

800

200

500

1,500

Fair value gains on land and buildings

100

Profit for 2011 Total recognised income for 2011

100

Dividends paid Issue of share capital during 2011 Balance at 31 December 2011


£000s

200

100

1,000

400

100 120

120

120

220

(20)

(20) 300

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

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 OverThe-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 Europe’s 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 – that’s $40 million a second!




4.6

Page 27

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 ...



Page 28

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.




Page 37

Chapter 14 Summary The Bank of England is the UK’s 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 UK’s 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 sector’s 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.



Page 38


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 company’s 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.




Page 39

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 sector’s excess short-term cash to private sector and institutional borrowers.

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. Invest in bills and provide loans and leases to companies.

Deposits by private individuals and by companies. Borrow from other banks when they are short of cash.

Channel private individuals’ excess short-term cash to private individuals to borrow to buy a house. Deposits from private individuals with a small, but increasing, amount from the money and bond markets.

Grant house-purchase mortgages and some personal loans. Surplus cash is invested in shortdated 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 indexlinked gilts.

Application of funds


Grant loans and overdrafts to customers. Surplus cash invested in other banks (using certificates of deposit), shortdated gilts and local authority bonds, bills of exchange and Treasury bills.

Contributions from employers and employees only. No borrowings.


Page 40


At a glance summary of financial institutions Institution

Investment trusts

Unit trusts

Role

Pooled investment vehicle, channels investors’ money into the Stock Market and other (mainly long-term) assets. Private individuals and some institutions buy shares. Also raise debt finance. Invest mainly in the longerterm markets: UK equities, UK gilts and other fixed interest, overseas equities, property.

Pooled investment vehicle which channels investors’ money into the UK and overseas stock markets.

Source of funds

Application of funds


Private individuals and some institutions buy units. Unit trusts do not borrow. Most unit trusts invest mainly in longer-term quoted securities: UK equities, UK gilts and other fixed interest, and overseas equities.

Open-ended investment companies Pooled investment vehicle, channels investors’ money into the Stock Market and other (mainly long-term) assets. Private individuals and some institutions buy shares. Also raise debt finance. Invest mainly in the longerterm markets: UK equities, UK gilts and other fixed interest, overseas equities, property.

Life insurance companies Pool mortality and investment risks by channelling savings into the long-term capital markets. Premium income from policyholders. Do not usually borrow money. 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.

General insurance companies Provide cover by pooling a variety of risks.

Premium income from policyholders. Do not borrow money. 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 nonsterling 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 UK’s 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

Assets Non-current assets Non-current assets (at original cost) Depreciation to date Current assets Inventories Trade receivables Cash Total assets Equity and liabilities Share capital (25p ordinary shares) Share premium account Retained earnings Total equity Non-current liabilities Loan stock Current liabilities Trade payables Tax payable Total liabilities Total equity and liabilities

2010 £000

2011 £000

302 (86)

344 (110)

41 21 43 321

35 25 45 339

45 21 96 162

50 24 110 184

140

130

7 12 159 321

17 8 155 339

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

Sales revenue Operating profit Finance costs Profit before tax Corporation tax Profit after tax

£000 251 47 10 37 11 26

The cashflow statement for Light Fantastic UK for the year 2011 (£000s) Cashflows from operating activities Cash generated from operations1

87

Interest paid

(10)

Tax paid

(15)


62

Cashflows from investing activities Purchase of machine

(50)

Sale of machine

4


(46)

Cashflows from financing activities Proceeds from share issue

8

Repayment of loan

(10)

Dividends paid

(12)


(14)

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


2 43 45


CT2: Q&A Bank Part 3 – Solutions

Page 29

Solution 3.31 Operating activities 

£62,000 has been generated from operating activities.

[½]



Inventory levels have decreased, which has generated free cash.

[½]



35   365  . The stock turnover period is now 51 days 

[½]



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. [½]



There has been an increase in the amount of credit given to customers.

[½]



25  The debtors turnover period is now 36 days   365  .

[½]



This use of cash might improve marketing and sales. On the other hand, the company could suffer from “bad debts”. [½]



The company has obtained more credit from its suppliers.

[½]



17  The creditors turnover period is now 25 days   365  .

[½]



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. [½]



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]



47 Interest of £10,000 has been paid. Interest cover is 4.7   , so the company’s

 251

 251

 251







 10 

profit covers these payments reasonably well.

[1]

Investing activities 

£46,000 has been used in investing activities.

[½]



The company has not made a profit or loss on the sale of a machine.

[½]



Since the company’s 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. [½]



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. [½]



As a result its gearing ratio has fallen from 46% 

[½]

140   100   162  140 

 130   100  .   184  130 



[½]

This will reduce the volatility of the company’s earnings and increase its asset 321  19   339  25  cover from 2.2   to 2.4  . 



to 41%

140





130

[½]



Dividends of £12,000 were paid. This is 6.6p per share

( 45∏120.25 ) .

[½] [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 II III

an investment bank an investment trust an insurance company

A B C D

if I and II only are correct if II and III only are correct if I only is correct if III only is correct

[2]

Question 5.2 Which of the following are NOT registered? I II III

shares commercial paper Eurobonds

A B C D

if I and II only are correct if II and III only are correct if I only is correct 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 B C D

the factor takes over all responsibility for credit analysis of new accounts. the factor must be a listed company. credit risk remains with the supplier. 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 B C D

no further tax on the £8.6m net profit. a further 10% tax on the £10m gross profits. a further 10% tax on the £8.6m net profits. 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 plc’s interest cover? A B C D

5 6 8 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 ...

[½]

... are taxed twice on the same income.

[½]

Double taxation relief is available on income and capital gains.

[1]

Tax paid overseas on overseas income can be offset against the liability to domestic tax on that income or capital gain. [1] The maximum offset is the rate of tax that would have been paid locally on the grossedup income. [1] For example, if a UK company has to pay 30% corporation tax and has paid 20% tax on its profit made in India then it will have to pay the additional 10% in the UK. If it has paid 40% tax on its profit in Norway, it pays no more tax in the UK. It cannot reclaim the “additional” tax paid in Norway. [1] [Maximum 4]



Page 8


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. [½]



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. [½]



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. [½] 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 today’s levels. [½]



CT2: Assignment X2 Questions

Page 7

Cashflow statement for the year ending 31 July 2011 (£000s) Cashflows from operating activities Cash generated from operations1

471

Interest paid

(500)

2

Tax paid

(30)

Net cash used in operating activities

(59)

Cashflows from investing activities Purchase of non-current assets

(2,450)


(2,450)

Cashflows from financing activities Proceeds from borrowings3

2,600

Dividends paid

(50)

Net cash generated from financing activities

2,550

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

41 13 54

Notes 1.

Net profit + depreciation + increase in trade payables – increase in trade receivables – increase in inventories (800 + 200 + (120 – 350) – (240 – 51) – (360 – 250))

2.

Tax payable at start of year + tax in respect of 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 company’s cashflow statement. [7] [Total 14] End of paper



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Page 13

Statement of financial position as at 30 June 2011 ASSETS Non-current assets Land and buildings1 Plant & machinery2 Current assets Inventories Trade receivables Total assets

£000s 918.34 300.00 1,218.34 19.00 90.00 109.00 1,327.34

EQUITY AND LIABILITIES Equity Ordinary share capital Share premium account Retained earnings3 Total equity Non-current liabilities Loan stock Current liabilities Bank overdraft Trade payables Tax Total liabilities Total equity and liabilities

200.00 300.00 145.34 645.34

600.00 6.00 54.00 22.00 82.00 682.00 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]


Page 14


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. [½] 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. [½] 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. [½] 

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 ... [½] or, alternatively, it could repay a loan or reward the shareholders (with a large dividend or an offer to buy back the shares). [½]

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. [½] Thirdly, the cashflow statement highlights the differences between profit and cash. [½] 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 company’s financial health. A company can be profitable but insufficiently liquid. [1]




Page 15

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 company’s cash balances. [1] Finally, the cashflow statement offers an objective statement of the company’s 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. [½]



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. [½]



While it seems reasonable to “finance” investment, it seems less reasonable to “finance” operating activities. [½]



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. [½]



The major outflow of funds from operating activities is the interest paid on the company’s loans. In fact, at the current level of activities it cannot even finance the current debt interest burden. [½]



Page 16




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. [½]



The company has preserved some cash by only paying tax due from previous years. However it has a large outstanding tax liability remaining. [½]



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 we’ve 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. [½]



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. [½] [Maximum 7]




Page 1

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:

ri  r f  i (rm  r f )  5%  1.5   3%  5%   2%

[2]

Solution X4.2

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

return on assets = ﬁ

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

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

Thus: return on equity = 14%



Page 2


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

b g = b u Í1 +

D 25 (1 - t )˘˙ = 1 ÈÍ1 + (1 - 0)˘˙ = 1.333 E ˚ Î 75 ˚

So, the return on the geared shares is: r f + b g (rm - r f ) = 6% + 1.333(12% - 6%) = 14%

[2]

Solution X4.3

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

Solution X4.4

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

D E ¥ net cost of debt + ¥ cost of equity D+E D+E

We can find the net cost of debt as follows: Net cost of debt = (1 - t ) ¥ gross cost of debt = 0.7 ¥ 7% = 4.9%



CT2-PU-13

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