财政/国家财政

英国 IOA Study Material for CT2 (财务与财务报表) 2009


C72-PC-09Combined Materia/s PackActEd Study Materials: 2009 EXaminationsSubject CT2Study guide for the 2009 examsCourse notesQuestion and Answer bankSeries X Assignments*Note: The Series X Assignment Solutions should also be suppliedwith this pack unless you chose not to receive them with your study materialIf you think that any pages are missing from this pack, please contact ActEd's admin teamby email at ActEdabpp or by phone on 01235 550005How to use the Combined Materia/s packGuidance on how and when to use the bined materials pack is set outin the study guide for the 2009 examsImportant: Copyright AgreementThis study material is copyright and is sold for the exclusive use of the purchaser Youmay not hire out, lend, give out, sell, store or transmit electronically or photocopy anypart of it. You must take care of your material to ensure that it is not used orcopied by anybody else. By opening this pack you agree to these conditionsThe Actuarial Education CompanyC IFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe faculty and Institute of actuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elsLegal action will be taken if these terms are infringed. Iraddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usingthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study GuidePage 12009 Study GuideSubject CT2IntroductionThis Study guide contains all the information that you will need before starting to studySubject Ct2 for the 2009 exams. Please read this Study guide carefully beforereading the Course Notes, even if you have studied for some actuarial exams beforeThe study guide includesinformation about the course structure and how it links to the tutorialsinformation about how the notes are writtenadvice on how to study efficiently and prepare for the exama summary of the Assignment and Mock Exam deadlinesdetails of what to do if you have a querythe full syllabusContentsSection 1 The Subject CT2 course structure Page ESection 2The courseSection 3 ActEd study supporPagSection 4 Information from the profession Page [14Section 5Study skillsPage 19Section 6 Frequently asked questionsPage 23Section 7 SyllabusPage 25Section 8 Summary of useful informationection 9 File tabsgThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 2CT2: Study GuideThe subject cT2 course structureThere are four parts to the Subject CT2 course. This should help you plan your progressacross the study session. The parts cover related topics and have broadly equal lengthsThe parts are broken down into chaptersThe following table shows how the parts, the chapters and the syllabus items relate toeach other. The end columns show how the chapters relate to the days of the regulartutorialsPartChapterTitleSyllabus Half 2 full 3 fullpages objectives day days daysI 1 The key principles of finance2Company ownership38Taxation(iv)Financial instrumentsUse of derivatives21(v)6Issue of sharesIntroduction to accounts8 The main accountsDepreciation and reserves(vill10Generating accountsGroup accounts and insurance pany 25Willaccounts12 Interpretation of accounts: security of loan 2313 Interpretation of accounts: shareholder 34(ix)imitations of account5 Weighted average cost of capital42(vii)16 Capital structure and dividend policyCapital project appraisal (1)(vii),(x)18 Capital project appraisal (2)47(vi),(x)ssary@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study GuidePage 32 The courseThe Course consists of Course Notes, the Question and Answer Bank and the series XAssignments. Collectively, these are referred to as the Combined Materials Pack(CMP)2.1 Course notesEach chapter of the Course Notes includes the Syllabus, a chapter summary and, whereappropriate, a page of important formulae or definitionsThe Syllabus for Subject CT2 has been written by the profession to state therequirements of the examiners. The relevant individual Syllabus Objectives areincluded at the start of each course chapter and a plete copy of the Syllabusincluded in Section of this Study Guide. We remend that you use the Syllabusan important part of your study. The Syllabus is supplemented by Core Reading, whichhas also been written by the profession. The purpose of Core Reading is to give theexaminers,tutors and students a clear, shared understanding of the depth and breadth oftreatment required by the Syllabus. In examinations students are expected todemonstrate their understanding of the concepts in Core Reading. Examiners have theCore Reading available when setting papersCore reading deals with each Syllabus objective. However, the Core reading inisolation is not ideal to pass the exam. Core Reading is supplemented by tuition materialthat has been written by ActEd to help you prepare for the exam. The Subject CT2Course Notes include the Core Reading in full, integrated throughout the course. Hereis an excerpt from some ActEd Course Notes to show you how to identify Core Readingand the ActEd material. Core Reading is shown in this bold fontNote that in the example given above, the index will fall if the actual share price goesbelow the theoretical ex-rights share price. Again, this is consistent with what wouldhappen to an underlying portfolioAfter allowing for chain-linking, the formula for the investment index ActEdbeesSN PThis is Coret)=1ReadingB(t)where Nit is the number of shares issued for the ith constituent at time tB(t) is the base value, or divisor, at time t.The Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Study GuideYou should not simply try to memorise the Core Reading(or, for that matter, the tuitematerial). Rather, you should understand the principles stated in the Core readindeveloped in the tuition material2.2 Question and Answer BankThe Question and Answer Bank provides a prehensive and balanced bank of examstyle questions with solutions and ments, which will be helpful as part of yourpreparation for the Subject CT2 exam. Some students like to attempt the questions fromthe relevant part of the Question and Answer Bank before attempting the correspondingassignment. Others use the Question and Answer Bank at the revision stage. Our adviceis to try out various approaches and pick the one that best suits youThe Question and Answer Bank is divided into five parts. The first four parts of theAnswer Bank include a range of short and long questions to test yourunderstanding of the corresponding part of the Course Notes. Part five of the Questionand Answer Bank consists of 100 marks of exam-style questions. You may wish to usethis as part of your revision closer to the examinations2.3 AssignmentsThe four Series X Assignments (xI to X4) cover the material in Parts 1 to 4respectively. Assignments XI and X2 are 80-mark tests and should take you two and ahalf hours to plete. Assignments X3 and X4 are 100-mark tests and should takeyou three hours to plete. The actual Subject CT2 examination will have a total of100 marksIf you order Series X Marking at the same time as you order the assignments, you canhoose whether or not to receive a copy of the solutions in advance- see the back of theorder form for details. If you choose not to receive the solutions with the studymaterial, we will send the assignment solutions to you when we mark your script (orfollowing the deadline date if you don t submit the assignment)@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study GuidePage 53 Acted study supportThis section lists the study support available from ActEd for Subject CT23.1 Combined Materials PackThe Combined Materials Pack(CMP)prises the Course Notes, the Question andAnswer Bank and the Series X Assignments, as already described3.2 Series y assignmentsThe Series Y Assignments prise two 100-mark assignments (Y1 Y2), eachcovering the whole course. Series Y is suitable for retakes who have previously usedthe Series X Assignments and for first-time sitters who want additional questionpractice3.3 Mock ExamTwo 100-mark mock exam papers are available for students as a realistic test of theirexam preparation- Mock Exam 2008 and Mock Exam 2009. Both are issued with fullmarking schedules and are available with or without markingMock Exam 2009 is pletely new. Mock Exam 2008 is also still available forSyllabus and Core Reading over the last year upd.students wanting extra practice. It has been updated to reflect any changes to the3.4 ActEd Solutions with Exam Technique(ASET)The ActEd Solutions with Exam Technique(ASET) contains ActEd's solutions to theSubject CT2 papers from April 2006 and September 2008, ie six papersplus ment and explanation. In particular it will highlight how questions might havebeen analysed and interpreted so as to produce a good solution with a wide range ofrelevant points. This will be valuable in approaching questions in subsequentexaminationsA"Mini-ASET" will also be available(from July 2009) covering the April 2009 ExamThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Study GuideIn addition, a discount is available if you have already purchased a full AsEt in aprevious year and wish to purchase this year's full AsEt in the same subject. PleaseemailActEd@bpp.fordetails3.5 CMP upgradeThe CMP Upgrade lists all significant changes to the Core Reading and ActEd materialso that you can manually amend your 2008 study material to make it suitable for studyfor the 2009 exams. The Upgrade includes replacement pages and additional pageswhere appropriate. If a large proportion of the material has changed significantly,making it inappropriate to include all changes, the upgrade will still explain what haschanged and if necessary remend that students purchase a replacement CMP orCourse Notes at a significantly reduced price. The CMP Upgrades can be downloadedfreeofchargefromourwebsiteat.acted.co.uk3. 6 Smart ReviseSmart Revise is an e-learning product containing over 300 questions to help you withyour revision. You can either download the program to use it off-line on your PC or usetheram on-line. Visit our website atacted co uk for information on how toaccess and register for Smart Revise. You can try a demonstration version of thesoftware for free before registering. Registration runs for one exam session and willautomatically expire after the exam. If you wish to re-use Smartfollowing session an additional fee will be payable3.7 Sound revisionIt is reported that only 30% of information that is read is retained but this rises to 50% ifthe information is also heardSound revision is a set of audio CDs, designed to help you remember the mostimportant aspects of the Core Reading. There are three CDs for Subject CT2The CDs cover the majority of the course, split into a number of manageable topicsbased on the chapters in the Course Notes. Each section lasts no longer than a fewminutes so it's perfect for the train, tube, or car journey on the way to work, or wheretaking folders and course notes is not practical@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study GuidePage 73.8 Revision notesActEd's Revision Notes have been designed with input from students to help you reviseefficiently. They are suitable for first-time sitters who have worked through the ActedCourse Notes or for retakes(who should find them much more useful and challenginthan simply reading through the course again). The Revision Notes are a set of sevenA5 spiral-bound booklets- perfect for revising on the train or tube to work. Eachbooklet covers one main theme of the course and includes Core Reading(with a set ofintegrated short questions to develop your bookwork knowledge), relevant past examquestions(with concise solutions) since April 2000, detailed analysis of key past examquestions and other useful revision aids3.9 FlashcardsFlashcards are a set of A6-sized cards that cover the key points of the subject that moststudents want to mit to memory. Each flashcard has questions on one side and theanswers on the reverse. We remend that you use the cards actively and test yourselfFlashcards may be used to plement your other study and revision materials. Theyare not a substitute for question practice but they should help you learn the essentialmaterial required3.10 MarkingYou can have your attempts at Assignments or Mock Exams marked using SeriesMarking, Mock Exam marking or Marking Vouchers. These are described belowMarking is not included with the CMP and you need to order it separatelyOn every assignment or mock exam that you submit for marking you must write youActEd Student Number clearly in the box on the cover sheet. your ActEd StudentNumber is printed on all personal correspondence from ActEd. This is not the same asyour ARN (Actuarial Reference Number), which is used by the profession. By filling inyour ActEd Student Number, you will help us to process and return your script morequickly. If you do not supply this information, your script may be delayedThe Actuarial Education CompanyC lFE: 2009 Examinations8CT2: Study GuideWhen pleting an assignment which you are having marked please also rememberthe following guidelinesLeave plenty of space for markers to write their ments- the less roomyou leave, the fewer helpful ments the marker will be able to addPhotocopy your assignment before posting it to ActEd -we'll be happy tomark your copy if your original script should get lost in the postOnly use current versions of assignments. Do not submit any assignmentsfrom the 2008 exam session We will return old versions of assignmentsunmarkedIdentify how much you pleted in the remended time- this will helpthe marker to advise you on your chances of passing the exam. Do not stopafter the allotted allocation of time however. Use the marker to get feedbackon all questions, even if the assignment takes you longer to plete than thetime allocatedGrade and ment on your previous assignment marker(where applicable)this helps us to improve the quality of future markinSubmission of assignments and mock exams by fax or emailMany students submit assignments and mock exams by post. However, in order toreduce the turnaround time for marking, we are happy to accept scripts submitted by faxIf you are planning to submit your assignments by fax, please read the instructions onthe assignment coversheet before pleting your assignment. When submitting scriptsy fax, you will need to plete the cover sheet in the usual way and fax this, togetherwith a Marking Voucher (if applicable) and your attempt at the assignment or mockexamAlternatively, you may wish to scan your script and submit a pdf file by email. Pleaseread the instructions on the assignment coversheet if you are interested in using thisapproach@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study GuidePage 9Series Marking and Mock Exam MarkingYou may buy marking for a specified series of assignments(eg Subject CT2 Series X)orMock Exam Marking for a specified subject (eg Subject CT2). By submitting yourscripts in line with our published remended submission dates, you will make steadprogress through the course. We also publish a set of final deadline dates- if you missthe final deadline date for an assignment or mock exam, your script will not be markedRemended submission dates and final deadline dates are set out on the summarypages at the end of this document. Once you have booked Series Marking or Mock ExamMarking, you will not be able to defer the marking to a future study periodIf you order Series X Marking at the same time as you order the assignments, you canchoose whether or not to receive a copy of the solutions in advance- see the back of theorder form for details. If you choose not to receive the solutions in advance . we willsend the assignment solutions to you when we mark your script (or following thedeadline date if you don t submit the assignment)Marking VouchersIf you would prefer not to be restricted to deadlines during the session, or a particularseries of assignments in any one study session, you may buy Marking Vouchers insteadEach Marking Voucher gives the holder the right to submit an attempt at any assignmenttive of the individualdeadlines, study session, subject or person. Marking Vouchers are valid for four yearsfrom the date of purchase. Expired Marking Vouchers cannot be refundedImportant informationAlthough you may submit your script with a Marking Voucher at any time, you will needto adhere to the explicit marking voucher deadline dates to ensure that your script isreturned before the date of the exam. The deadline dates are given on pages B4to 35 ofthis study guideIf you live outside the UK you must ensure that your last script reaches the ActEd officeearlier than this to allow the extra time needed to return your marked scriptSubmission dates and deadlinesYour preparation for the exam should be based on a programme of sustained study overthe whole session. If you are having your attempts at the assignments marked by ActEd,you should submit your scripts regularly throughout the sessionThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 10CT2: Study GuideIf you are attempting the assignments or mock exams you should aim to submit scriptsaccording to the schedule of remended dates set out in the summary at the end of thisdocument. This will help you to pace your study throughout the session and leave andequate amount of time for revision and question practice. Scripts submitted after thedeadline date will not be marked. It is your responsibility to ensure that scripts areposted in good time.Important informationThe remended deadline dates are realistic targets for the majority of students. Yourscripts will be returned more quickly if you submit them well before the final deadlinedates3.11 TutorialsActEd tutorials are specifically designed to develop the knowledge that you will acquirefrom the course material into the higher level understanding that is needed to pass theexam. We expect you to have read the relevant part of the Course Notes beforeattending the tutorial so that the group can spend time on exam questions and discussionto develop understanding rather than basic bookworkActEd run a range of different tutorials at various locations. Full details are set outActEd's Tuition Bulletin, which is sent regularly to all students based in the UK, EireandSouthafricaandisalsoavailablefromtheactedwebsiteat.actedco.ukTaught CoursesWe offer 4-day Taught Courses in some subjects. Each day will cover one part of thecourse. You will not be expected to have read the relevant part of the notes beforeattending as the tutor will introduce the material, key concepts and principles that youwill need to master for their exam. The course will not replace the need to read thenotes but it will enable you to work through the material at a far quicker pace followinthe tutorial than would otherwise be the caseAlthough the courses will involve more tutor-led sessions, simple examples, exercisesand questions will be used to develop your understanding. Therefore, some activestudent participation will still be required. If you attend a taught course, you may alsolike to consider a block tutorial or a Revision Day closer to the exams to provide someguided exam-style question practice and additional supportSee the Tuition bulletin for further detail@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study GuideRegular and Block TutorialsYou can choose one of the following types of tutorialRegular Tutorials(four half days, two full days or three full days) spread overthe sessionA Block Tutorial (two or three full days) held 2 to 8 weeks before the examThe regular Tutorials provide an even progression through the course. block tutorialscover the whole courseRevision DaysRevision Days are intensive one-day tutorials in the final run-up to the exam. They areparticularly suitable for first-time sitters who attended Regular tutorials and would liketo spend a day close to the exam focusing on the course or retakes who have alreadyded ActEd tutorials. Rorys give yopracinterpreting and answering past exam questions and to raise any outstanding querieswith an Acted tutor These courses are most suitable if you have previously attendedRegular tutorials or a block Tutorial in the same subjectDetails of how to apply for ActEd's tutorials are set out in our Tuition Bulletin, which issent regularly to all students based in the uK, Eire and South africa and is alsoavailablefromtheActedwebsiteat.actedco.uk3.12 Queries and feedbackFrom time to time you may e across something in the study material that is unclearto you. The easiest way to solve such problems is often through discussion with friendscolleagues and peers-they will probably have had similar experiences whilst studyinIf theres no-one at work to talk to then use acted's discussion forum at.acted.co.uk/forums(orusethelinkfromourhomepageat.actedco.uk)Our online forum is dedicated to actuarial students so that you can get help from fellowstudents on any aspect of your studies from technical issues to study advice. You couldalso use it to get ideas for revision or for further reading around the subject that you arestudying. ActEd Tutors will visit the site from time to time to ensure that you are notbeing led astray and we also post other frequently asked questions from students on theforum as they ariseThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 12CT2: Study GuideIfyouarestillstuck,thenyoucansendqueriesbyemailtoCT2@bpp.orbyfaxto01235 550085 (but we remend that you try the forum first). We will endeavour tocontact you as soon as possible after receiving your query but you should be aware thatit may take some time to reply to queries, particularly when tutors are away from theoffice running tutorials. At the busiest teaching times of year, it may take us more thana week to get back to youIf you have many queries on the course material, you should raise them at a tutorial ofbook a personal tuition session with an ActEd Tutor. Information about personal tuitionis set out in our current brochure. Please email ActEd abpp. for more detailsEach year ActEd Tutors work hard to improve the quality of the study material and toensure that the courses are as clear as possible and free from errors. We are alwayshappy to receive feedback from students, particularly details concerning any errors,contradictions or unclear statements in the courses. If you have any ments on thiscoursepleaseemailthemtoCT2@bpp.orfaxthemto01235550085The ActEd Tutors also work with the profession to suggest developments andimprovements to the Syllabus and Core Reading. If you have any ments orconcerns about the Syllabus or Core Reading, these can be passed on via ActEdAlternatively, you can address them directly to the Professions Examination Team atNapier House, 4 Worcester Street, Oxford, OXI 2Aw or by email toexaminations(@actuaries. org.u@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study Guide3. 13 The ActEd we bsiteTheActedwebsiteat.acted.co.ukcontainsmuchusefulinformationonallaspects of ActEd's products and services, includingcopies of the Study Guide in every subjectthe current Student Brochure and application formsa link to acted's online storethe latest version of the Tuition Bulletin, including details of finalisation datesand all new coursedetails of how to organise tutorials at a convenient location for youdetails of any minor corrections to the study materialadvice on study and a blank personal study plandetails of remended assignment submission dates and deadline datesa link to the acted discussion forumThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 14CT2: Study Guide4 nformation from the profession4. 1 The Profession's CopyrightAll of the course material is copyright. The copyright belongs to Institute and FacultyEducation Ltd, a subsidiary of the Faculty of Actuaries and the Institute of actuaries.The material is sold to you for your own exclusive use. You may not hire out lend,give, sel transmit electronically, store electronically or photocopy any part of it. Youmust take care of your material to ensure it is not used or copied by anyone at any time.Legal action will be taken if these terms are infringed. In addition, we may seek to takedisciplinary action through the profession or through your employeThese conditions remain in force after you have finished using the course.4. 2 Changes to the Syllabus and Core ReadingThe Syllabus and Core Reading are updated as at 31 May each year. The exams inApril and September 2009 will be based on the Syllabus and Core reading as at 3 1 may2008We remend that you always use the up-to-date Core Reading to prepare for theexams4.3 Core Reading accreditationThe faculty and Institute of Actuaries would like to thank the numerous people whohave helped in the development of this material and in the previous versions of CoreReadingMaterial from the Auditing Practices Board in this Core Reading is reproduced by kindpermission of the Auditing Practices Board. For further information please visit.frc.org.uk/apborcall+44(0)20749223004.4 Past exam papersYou can download some past papers and reports from the profession's website at.actuaries.org.uk.Followtheactuarialeducation"and"currentstudents"linksfrom the home page@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study Guide4.5 The profession 's libraries and websiteAll students are entitled to use the professions libraries in Edinburgh, London andOxford. The following services are offeredLoansYou can borrow books by post if you do not live or work near one of the libraries. Thelibraries stock most publications on the list of suggested further reading for the CtSubjects and have multiple copies of the popular titlesPhotocopiesThe library staff can post photocopies to you. The cost is 20p per sheet(f5. 00 postageand packing added for destinations outside the Uk)EnquiriesThe library staff will always help with enquiries. They will try to obtain items not heldin stock and can advise on access to other libraries. they pile lists of references onspecialist topics on requestStudy facilitiesAll three libraries have fortable quiet study space. Past exam papers, ExaminersReports, ActEd Course notes and core reading are all available for referenceWebsiteYou can search the library catalogue on the website and order items online. Manycatalogue records include links to full text documents for downloading. You can alsoaccess the Publications Shop and order items for purchase. The website is a freeinformation resource for the latest thinking from the profession. You will find briefingstatements,press releases, responses to consultations, CMI reports, conference paperssessional meeting papers and the latest newThe actuarial education section contains practical information such as exam dates, paspapers and reports, syllabuses, the Student Handbook, guidance on study and examtechniques and the lists of suggested additional readingThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 16CT2: Study Guidebookmark these pagesInformation for students://.actuariesorguk/studentsExams information://.actuaries.orguk/students/examsLibrary services://.actuaries.org.uk/knowledge/libraryPublications shop://.actuaries.org.uk/members/transactions/publicationsshop4.6 Further readingThe exam will be based on the relevant Syllabus and Core Reading and the Actedcourse material will be the main source of tuition for studentHowever, some students may find it useful to obtain a different viewpoint on aparticular topic covered in Subject CT2. The following list of further reading forSubject CT2 has been prepared by the Institute and Faculty. This list is not exhaustiveand other useful material may be availableFinancial statement analysis in Europe. - Samuels, JM; Brayshaw, R E: Craner, JM.Chapman Hall, 1995. 454 pages.-ISBN:0 412 54450 4Fundamentals of financial management. -Brigham, Eugene F: Houston, Joel F.-9thed -Harcourt Brace, 2000. 959 pages.-ISBN: 0 5Available from the publications UnitHow to read the financial pages. -Brett, M. 2nd ed. Random House Business books2003.430 pages.ISBN:0712662596Interpreting pany reports and accounts. - Holmes, Geoffrey, Sugden, alarGee, Paul.-8th ed.-Pearson Education, 2002. 298 pages.-ISBN: 0 273 65592 2Available from the Publications Unit.Principles of corporate finance. -Brealey, Richard A; Myers, Stewart C. -7th edMcGraw-Hill, 2003. 1004+ appendices pages. -ISBN: 007115144 3@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study Guide4.7 CalculatorsThe profession has issued the following advice. However, you are stronglyremendedtoconsult.actuaries.orgukforthelatestpositionCandidates may use electronic calculators in all the examinations subject to thefollowing conditionsCandidates must provide their own calculatorsUnder no circumstances should hand-held personal puters, ofdescription, be taken into the examination roomCalculators must be silent, have visual display only and be battery- or solar-Any stored data and /or stored program facilities must be cleared before thecalculator is taken into the examination roomCandidates are advised that in all calculations intermediate results shouldnormally be shown to gain full marksThe following calculators ONLY are permittedCasio FX85 (with or without any suffix)Hewlett Packard HP9SHewlett Packard HP 12C (with or without any suffix)Sharp el531(with or without any suffixTexas Instruments BA II Plus(with or without any suffix)Texas Instruments Tl-30 (with or without any suffix)The list of permitted calculators will be reviewed each year by the educationCommittee. Student ments are considered and should be forwarded to theExaminations Team for submissionCalculators which have been discontinued by the manufacturer, or which the educationCommittee has decided to remove for any reason will remain on the list for one year togive students time to bee familiar with an alternativeCandidates are advised that invigilators will be asked to report the use of calculators noton the permitted list and the board of Examiners will decide how to treat such cases atthe results meetingsThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 18CT2: Study GuideNo extra time will be allowed for candidates who do not use calculators or whosealculators break down in the course of the examination. Exam supervisors will nothave extra batteries or calculators@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study Guide5 Study skills5.1 The CT Subject examsThe Core Reading and exam papers for these subjects tend to be very technical. Theexams themselves have many calculation and manipulation questions. The emphasis inthe exam will therefore be on understanding the mathematical techniques and applyingthem to various, frequently unfamiliar, situations. It is important to have a feel for whatthe numerical answer should be by having a deep understanding of the material and bydoing reasonableness checksSubjects CT2 and CT7 are more"wordy"than the other subjects, including an"essaystyle" question in Subject cT7Since there will be a high level of mathematics required in the courses it is importantthat your mathematical skills are extremely good. If you are a little rusty you may wishto consider buying the Foundation ActEd Course(FAC) available from ActEd. Thiscovers all of the mathematical techniques that are required for the ct Subjects, some ofwhich are beyond A-Level (or Higher Level) standard. It is a reference document towhich you can refer when you need help on a particular topicYou will have sat many exams before and will have mastered the exam and revisiontechniques that suit you. However it is important to note that due to the high volume ofwork involved in the CT Subjects it is not possible to leave all your revision to the lastminute. Students who prepare well in advance have a better chance of passing theirexams on the first sittingMany of the exam questions are lengthy and most students find it difficult to pletethe paper in 3 hours. Therefore it is important to find ways of maximising your score inthe shortest possible timeWe remend that you prepare for the exam by practising a large number of examstyle questions under exam conditions. This willhelp you to develop the necessary understanding of the techniques requiredhighlight which are the key topics which crop up regularly in many differenthelp you to practise the specific skills that you will need to pass the examThere are many sources of exam-style questions. You can use past exam papers, theQuestion and Answer Bank(which includes many past exam questions), assignments,mock exams. Revision notes and asetThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Study Guide5. 2 Overall study planWe suggest that you develop a realistic study plan, building in time for relaxation andllowing some time for contingencies. Be aware of busy times at work, when you maynot be able to take as much study leave as you would like. Once you have set your planbe determined to stick to it. You dont have to be too prescriptive at this stage aboutwhat precisely you do on each study day. The main thing is to be clear that you willover all the important activities in an appropriate manner and leave plenty of time forrevision and question practiceAim to manage your study so as to allow plenty of time for the concepts you meet inthis course to" bed down"in your mind. Most successful students will probably aim toplete the course at least a month before the exam, thereby leaving a sufficientamount of time for revision. By finishing the course as quickly as possible, you willhave a much clearer view of the big picture. It will also allow you to structure yourrevision so that you can concentrate on the important and difficult areas of the courseAsampleCtsubjectstudyplanisavailableonourwebsiteat.acted.co.uk.itincludes details of useful dates, including assignment deadlines and tutorial finalisationda5.3 Study sessionsOnly do activities that will increase your chance of passing. Try to avoid includingactivities for the sake of it and don t spend time reviewing material that you alreadyunderstand. You will only improve your chances of passing the exam by getting on topof the material that you currently find difficultIdeally, each study session should have a specific purpose and be based on a specifictask, eg"Finish reading Chapter 3 and attempt Questions 1.4, 1.7 and 1.12 from theQuestion and Answer Bank", as opposed to a specific amount of time, eg"Three hoursstudying the material in Chapter 3Try to study somewhere quiet and free from distractions(eg a library or a desk at homededicated to study). Find out when you operate at your peak, and endeavour to study atthose times of the day. This might be between &am and 1Oanevening. Take short breaks during your study to remain focused -it's definitely timefor a short break if you find that your brain is tired and that your concentration hasstarted to drift from the information in front of you@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study GuidePage 215.4 Order of studyWe suggest that you work through each of the chapters in turn. To get the maximumbenefit from each chapter you should proceed in the following orderRead the Syllabus objectives. These are set out in the box on Page I of eachchapterRead the Chapter Summary at the end of each chapter. This will give you a usefuloverview of the material that you are about to study and help you to appreciate thecontext of the ideas that you meet3. Study the Course Notes in detail, annotating them and possibly making your ownnotes. Try the self-assessment questions as you e to them. Our suggestedsolutions are at the end of each chapter. As you study, pay particular attention tothe listing of the Syllabus Objectives and to the Core ReadinRead the Chapter Summary again carefully. If there are any ideas that you cantremember covering in the Course notes read the relevant section of the notesagain to refresh your memoryYou may like to attempt some questions from the Question and Answer Bank when youave pleted a part of the course. It's a good idea to annotate the questions withdetails of when you attempted each one. This makes it easier to ensure that you try all ofthe questions as part of your revision without repeating any that you got right first timeOnce youve read the relevant part of the notes, tried a selection of exam-style questionsfrom the Question and Answer Bank(and attended a tutorial, if appropriate), you shouldttempt the corresponding assignment. If you submit your assignment for marking,spend some time looking through it carefully when it is returned. It can seem a bitdepressing to analyse the errors you made, but you will increase your chances ofpassing the exam by learning from your mistakes. The markers will try their best toprovide practical ments to help you to improveIt's a fact that people are more likely to remember something if they review it from timeto time. So, do look over the chapters you have studied so far from time to time.Ituseful to re-read the Chapter Summaries or to try the self-assessment questions again afew days after reading the chapter itself.To be really prepared for the exam, you should not only know and understand the CoreReading but also be aware of what the examiners will expect. Your revision programmeshould include plenty of question practice so that you are aware of the typical style,content and marking structure of exam questions. You should attempt as many questionsas you can from the Question and Answer Bank and past exam paperThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 22CT2: Study Guide5.5 Active studyHere are some techniques that may help you to study activelyDont believe everything you read! Good students tend to question everythingthat they read. They will ask "why, how, what for, when? " when confrontedwith a new concept, and they will apply their own judgement. This contrastswith those who unquestioningly believe what they are told, learn it thoroughly,and reproduce it (unquestioningly? in response to exam questions2. Another useful technique as you read the Course Notes is to think of possiblequestions that the examiners could ask. This will help you to understand theexaminers' point of view and should mean that there are fewer nasty surprises inthe exam room! Use the Syllabus to help you make up questionsAnnotate your notes with your own ideas and questions. This will make youstudy more actively and will help when you e to review and revise thematerial. Do not simply copy out the notes without thinking about the issues4. Attempt the questions in the notes as you work through the course. Write downyour answer before you check against the solutionAttempt other questions and assignments on a similar basis, ie write down youranswer before looking at the solution provided. Attempting the assignmentsunder exam conditions has some particular benefitsIt forces you to think and act in a way that is similar to how you willbehave in the examWhen you have your assignments marked it is much more useful if themarkers ments can show you how to improve your performanceInder exam conditions than your performance when you have access to thenotes and are under no time pressure.The knowledge that you are going to do an assignment under examconditions and then submit it(however good or bad) for marking can acta powerful incentive to make you study each part as well as possibleIt is also quicker than trying to write perfect answers6Sit a mock exam 4 to 6 weeks before the real exam to identify your weaknessesand work to improve them. You could use the mock exam written by Acted or apast exam paper.@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study Guide6 Frequently asked questionsWhat knowledge of earlier subjects should / have?A: Very little knowledge of earlier subjects is in fact required for Subject CTThere is quite a bit of overlap between Subject CTI and Subject CT2. Forexample, you will study various financial instruments, including derivatives, 1oth subjects. However, the emphasis will be different. In Subject Ctl you willbe concerned with technical issues such as the pricing of products, whereas inSubject CT2 you will be more concerned with the way in which these productscan be used by a pany. Similarly, in the area of investment appraisal, CTIconcerned with the technicalities of the various methods of appraisal, whereascT2 is concerned with the relative merits of the various methodsQ: What are the key question answering skills?AParts 2 and 3 of thetheThis work can be quite plex and it helps to have a quick numerical brain. Alot of question practice in this area will help. Examination questions often askyou to remend action for a particular firm in a particular situation. You needto know and understand the course content and be able to apply principles to agIven situationQ: What should do if i discover an error in the courseA: If you find an error in the course, please check our website at.acted.co.uk/html/papercorrections.htmto see if the correction has already been dealt with. Otherwise please senddetails via email to CT2( abpp. or send a fax to 01235 550085Q: What calculators am / allowed to use in the exam?A: You are allowed to use the following calculatorsCasio FX85 (with or without any suffix)Hewlett Packard HPoSHewlett Packard HP 12C(with or without any suffix)Sharp el531 (with or without any suffix)Texas Instruments Ba II Plus(with or without any suffix)Texas Instruments Tl-30(with or without any suffix)The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 24CT2: Study Guidecurrent advice from the profession. However, we stronglyremend that you check on the professions website for the latest details@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study Guide7 SyllabusThe full Syllabus for Subject CT2 is given here. The numbers to the right of eachobjective are the chapter numbers in which the objective is covered in the Acted courseAimThe aim of the Finance and Financial Reporting subject is to provide a basicunderstanding of corporate finance including a knowledge of the instruments used bpanies to raise finance and manage financial risk and to provide the ability teinterpret the accounts and financial statements of panies and financial institutionsLinks to other subjectsSubject CTl Financial Mathematics: uses this subject to provide a grounding infinancial mathematics and investmentsSubject CAl- Core Applications Concepts: develops some of the concepts introducedin this subject.Subjects St5- Finance and Investment Specialist Technical A, ST6- Finance andInvestment Specialist Technical B, SA5- Finance Specialist Applications and SA6Investment Specialist Applications: develop the technical and practical applications oftopics introduced in this subjectThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Study GuideObjectivesOn pletion of this subject the candidate will be able to(i) Demonstrate a knowledge and understanding of the principal terms in use ininvestment and asset managemer(whole course: see Index(after the Study Guide) and Glossary in Chapter 19)(ii) Demonstrate an awareness of the key principles of finance.Chapter 1)Outline the relationship between finance and the real resources andobjectives of an organisationOutline the relationship between the stakeholders in an organisation(including lenders and investors)3. Outline the role and effects of the capital marketsOutline agency theoryOutline the theory of the maximisation of shareholder wealth(ii) Describe the structure of a joint stock pany and the different methods bywhich it may be financedChapter 2)Outline the distinctive characteristics of sole traders, partnerships andlimited panies as business entitiesDescribe the different types of loan and share capitalDistinguish between authorised and issued share capitalDiscuss the economic advantages and disadvantages of a limitedpany as a business entityOutline the main differences between a private and public pany6. Outline the different types of medium-term pany financehire purchaseeasingbank loans@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study GuidePage 27Describe the following different types of short-term pany financebank overdraftsbills of exchangemercial paper.(iv) Describe the basic principles of personal and corporate taxation.( Chapter 3)Describe the basic principles of personal taxationescre basic principles of the taxation of capital gains3. Describe the basic principles of pany taxationExplain the different systems of pany taxation from the points ofview of an individual shareholder and the pany.5. Outline the basic principles of double taxation relief.(v) Demonstrate a knowledge and understanding of the characteristics of theprincipal forms of financial instrument issued or used by panies and theways in which they may be issuedChapters 4, 5, 6I. Outline the reasons a pany might have for seeking a quotation on thestock exchangeDescribe the characteristics, from an issuer's point of view ofunsecured loan stocksordinary sharesconvertible unsecured loan stocksconvertible preference shareswarrantsfloating rate notesoptions issued by paniesThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Study Guide3. Describe the characteristics and possible uses by a non-financialpany offinancial futuresinterest rate and currency swaps4. Outline the following methods of obtaining a quotation for securitiesoffer for sale by tenderoffer for subscriptionintroductionDescribe the following types of new issues to existing shareholdersp issuerights issueDescribe the role of underwriting in the issue of securities(vi) Discuss the factors to be considered by a pany when deciding on its capitalstructure and dividend policyChapter 16)Describe the effect that the capital structure used by a pany will haveon the market valuation of the panyDescribe the effect of taxation on the capital structure used by apany.Discuss the principal factors that a pany should consider in settingdividend policyDiscuss alternative ways of distributing profits, such as buybacks5. Discuss the effect that the dividend policy will have on the marketvaluation of a pany.@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study Guide(vii) Define what is meant by a pany's cost of capital and discuss how its cost ofcapital interacts with the nature of the investment projects it undertakesChapters 15, 17, 18)Describe how to calculate a pany's weighted average cost of capitalDiscuss the different methods used for project evaluation3. Describe methods monly used to evaluate risky investmentsincluding probability trees, simulation and certainty equivalents4. Discuss the issues in establishing the required rate of return for a capitaprojec(viii) Describe the basic construction of accounts of different types and the role andprincipal features of the accounts of a pany( Chapters7,8,9,10,11)Explain why panies are required to produce annual reports andaccountsEcountingthe drawing up of pany accountsExplain the purpose of aIne statementcashflow statementnd of the notes to the accountsConstruct simple balance sheets, ine statements and cashflowstatementsUnderstand the structure and content of insurance pany accounts6. Explain what is meant by the terms subsidiary pany and associatedpany.Explain the purpose of consolidated accounts8. Explain how goodwill might arise on the consolidation of groupaccountThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Study GuideExplain how depreciation is treated in pany accounts10. Explain the function of the following accounts- share capital, otherreserves and retained earnings(ix) Interpret the accounts of a pany or a group of panies and discuss thelimitations of such interpretationChapters 12, 13Calculate and explain priority percentages and gearing2. Calculate and explain ine cover and asset cover for loan capitalcribe the possible effects of interest rate movements on a highlygeared panyCalculate and explain price earnings ratio, dividend yield, dividend coverand eBitDaExplain net earnings per shareCalculate and explain accounting ratios which indicateprofitabilityliquiditefficiency.Discuss the shortings of historical cost accountingDiscuss the limitations in the interpretation of pany accounts9. Discuss the ways that reported figures can be manipulated to create afalse impression of a pany's financial position@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study Guide(x) Show how financial techniques can be used in the assessment of capitalInvestment projectsChapters 15, 17, 18)1. Discuss the principal methods that may be used to determine the viabilitytalDiscuss the factors underlying the choice of discount rate within projectassessment includingthe assumptions and limitations in the use of the weighted averagethe allowance for leveragethe allowance for riskDiscuss the methods that may be used for identifying the risks that maybe present for different types of projectDiscuss suitable techniques for ascertaining the probability of occurrenceof different risks over varying timescales and the financial impact ofoccurrence5. Discuss suitable techniques for ascertaining the distribution of thepossible financial outes of a capital projectThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 32CT2: Study GuideThis page has been left blank so that you can remove and use thesummary of useful information.@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study Guide8 Summary of useful information- Subject c28.1 Structure of the coursePart ChapterNo of Syllabus Half 2 full 3 fullpages objectives day days daysIThe key principles of financeCompany ownershipFinancial instrumentsUse of derivatives21(v)6 Issue of shares(v)Introduction to accountsThe main accounts(viii)Depreciation and reserves10Generating accounts2211 Group accounts and insurance pany12 Interpretation of accounts: security of 23(ix)nterpretation of accounts: shareholder(ix)214 Limitations of accounts(ix)weIghted16 Capital structure and dividend policy7 Capital project appraisal(1)(vi),(x)318(2)47(vi),(x)SendqueriesorfeedbackonSubjectCt2byemailtoCt2@bpP..Acted'swebsite.acted.co.ukTheprofessionswebsite.actuaries.orgukThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Study Guide8. 2 Assignment Deadlines- CT SubjectsFor the session leading to the April 2009 exams-CT SubjectsMarking vouchersSubjectsAssignmentsMocksCTs with exams in week beginning 20 April 200925 March 20091 April 2009Other CT subjectsI April 20098 April 2009Series X and Y AssignmentsRemendedFinal deadlineSubjectsAssignmentsubmission datedateCTs with exams in week beginning19 November 200820 April 200921 January 2009Other CT subjects26 November 200828 January 2009CTs with exams in week beginning20 April 20093 December 200811 February 2009X2Other CT subjects10 December 200818 February 2009CTs with exams in week beginning20 April 200928 January 20094 March 2009Other CT subjects4 February 200911 March 2009CTs with exams in week beginning20 April 200918 February 20091 8 March 2009Other CT subjects25 February 200925 March 2009CT1-Ct811 March 20091 8 March 2009CT1-CT81 8 March 200925 March 2009Mock ExamsSubjectsRemendedFinal deadlinesubmission datedateCTs with exams in week beginning 20 April 200925 March 20091 April 2009Other CT subjects1 April 20098 April 2009We suggest that you work to the remended submission dates where possible. Please remember thatthe turnaround of your script is likely to be quicker if you submit it well before the final deadline date.@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study GuideFor the session leading to the September 2009 exams- CT SubjectsMarking vouchersSubjectsAssignmentsMocksCTs with exams in week beginning 28 Sept 2009 2 September 20099 September 2009Other CT subjects9 September 200916 September 2009Series X and y AssignmentsSubjectsAssignmentRemendedFina deadline datesubmission dateCTs with exams in week beginning1 July 200915July200928Sept2009XIOther CT subjectsJuly 2009CTs with exams in week beginning200929July200928Sept2009Other CT subjects22July20095 august 2009CTs with exams in week beginning29July200912 August 200928Sept2009Other Ct subiects5 August 200919 August 2009CTs with exams in week beginning200926 August 200928Sept2009Other CT subjects19 August 20092 September 2009CT1-CT8YI5 August 2009CTI-CT8Y219 August 20092 September 2009Mock ExamsommendedSubjectsmission date Final deadline dateCTs with exams in week beginning 28 Sept 2009 26 August 20099 September 2009Other CT subjects2 September 2009 16 September 2009We suggest that you work to the remended submission dates where possible. Please remember thatthe turnaround of your script is likely to be quicker if you submit it well before the final deadline dateAt the time of going to print, the Profession had not confirmed the order of the 2009 exams. An up-todate version of these Assignment deadlines, showing the specific subjects in each sub-group, is availableonourwebsiteat.acted.co.ukThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Study GuideThis page has been left blank so that you can cut out and use the file tabs@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Study GuidePage 379 File tabsYou might want to use the tabs printed below to label your course files. You willneed two course files for the Combined Materials Pack but we have given you nineso that you can choose which ones to cut out in order to label your fileCT2CT2CT2Finance andinance andFinance andFinancialFinancialFinancialReportingReportingReporting2009 Exams2009 Exams2009 ExamsAssignmentsQuestionsCT2CT2CT2Finance andFinance andFinance andFinancialFinancialFinancialReportingReportingReporting2009 Exams2009 Exams2009 ExamsFile 1File 2NotesCT2CT2CT2Finance andFinance andFinance andFinancialFinancialFinancialReportingReportingReportingAssignmentsThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Study GuideThis page has been left blank so that you can cut out and use the file tabs@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: IndexCT2 IndexChapter 19 contains a glossary of principal termsAccounting standardsCh7 p5Statutory requirementsCh7 p6-7International Accounting Standards boardCh7 p8Case for and against accounting standardsCh7 p9Accounting Standards Board(ASB)Ch7 p18Accruals conceptCh7 p21Ch8p2021ChIo p6Adverse opinionCh7 p16Agency theoryChI p1l-12Annual capital chargeChI7 pl2Annual reportCh7p12-13Asset coverChl2p10-11Asset gearingCh2p13-16Asset priority percentagesCh12 pl2Asset utilisation ratioChl3p19,21Associate panyChll pll-12Auditing practices boardCh7p14,16Auditors'reportCh7p12-17Authorised share capitalCh4 p16BBalance sheetCh8p2-11Ch10p7-11Chll pl7-19Chl5p21-27Ch18 p6-10Bills of exchangeCh2p23-25Business entity conceptCh7 p21CCapitalCh8p2,7-8Ch9 p8Capital allowancesCh3 p9Capital Asset Pricing Model(CAPm)Chl517-27The Actuarial Education CompanyIFE: 2009 ExaminationsPage 2CT2: IndexCapital budgeChI p4-7Capital gains in the ine statementCh8 pl7Capital gains taxCh3 p1l-14Capital marketsChI p18Capital projectCh17p3-4Capital structureCh6p3-20Cashflow statementCh8p20-27Ch10 p12Certainty equivalentChI8 p28Commercial paperCh2p25-26ompaniesLimitedCh2 p5-6PrivateCh2p9-10PublicCh2p9-10Companies ActCh7 p6-7Consistency concept7p2Consolidated accountsChll p2-12Ch4p26-29CostCh7p1920Cost of debtCh6p2931ChI6 p14-28Cost of sales18 p13Ch4p7,8,10Credit itemsCh10 p4-5Credit riskCh5p3,11Credit saleCh2p15-16CreditoCh8 p8Creditors'turnover ratioh13p27-28Currency swapChp12-15Current assetCh8 p6-7Chl p5Current liabilitiesCh8 p8-9Current ratioCh13p22-23DebentureCh4 p5-8Debit itemsChIo p2-58p7Debtors ' turnover ratioChl3p26-27C lFE: 2009 Examinationshe Actuarial Education CompanyCT2: IndexPage 3DepreciationCh3 p9Ch8p4,6,13,4,21,25ChIo p5Ch14p2.5Disclaimer of opinionCh7 p15Discount rateCh18p3-10Dividend (recording in accounts)Ch8p15-16DividendCh13p910Dividend policy.……Chl6p21-28Dividend yieldCh13 p8-9Double entry accountingChlo p2, 7Double Taxation Relief (dtr)Ch3 D16Dual aspectCh7 p22EEarnings per shareCh8 p16EBITDACh13 ploEmphasis of matter paragraphs…Ch7p15EquitCh4p15-20Ch8 p7-8Ch9 p8Equity risk premiumh15 p15-17EurobondsCh4p10-13factoringFIFOCh14 p4Financing decisionFloating-rate notesCh4p13-14ForwardCh5Franked ineCh3 peCh4 p15FuturesCh5 p2-8Gearing…Ch12p13-18Going corCh7p23-24GoodwillCh7 p19Ch8 pChll p5-8The Actuarial Education CompanyIFE: 2009 ExaminationsPage 4CT2: IndCh8 p16Group accountsChll p2-12HHire Purchase(HP)Ch2p14-15Historical cost accountingCh14 p2-3Hurdle rateChl p21Ine coverCh12 p6-8Ine gearingCh12 p18Ch12Ine statementCh8p12-19Chlo p7-11ChIl p16-17Indexation allowanceCh3 p12Information asymmetriespCh2 p12Insurance pany accountsChll p14-19Intangible assetCh8 p5Ch14 p5Interest rate swapCh5 p12-15Internal rate of returnCh17 p10-1International accounting standardsInternational Accounting Standards boardCh7 p8IntroductionCh6p10-11Inventories(stockChlo p6Investment submissionChl8 p31Issued shCh4 pIp6easingCh2 p16-17Liabilitiesh8p8-10LIFOCh14 p4Limited Liability Partnership (LLp)Ch2 p7-8ListingCh6 pLoansBank loansCh2p18-19Loan facilitip18Multi-currency loansCh2 p19Syndicated loansCh2 p19C lFE: 2009 Examinationshe Actuarial Education CompanyCT2: IndexPage 5Loan stockCh4 p5-8UnsecuredCh4p8-10MmarginsMarket riskCh5 p12MatchiCh7 p22Ch9 p2materiality conceptCh7p22-23Miller and modiglianiCh15p6-1Minority inteChll p8-11ent conceptCh7 p20Monte Carlo simulationCh17 p24-26NNet asset value per shaChl3p12-13Net current assetsCh8 p8Net present valueCh17 p8-10Net profitNil-paid rightCh6p16,20Nominal returnsCh17 pl7Non-current assetsCh8 p4-6Ch16 p5Non-current liabilities…Ch8p9Non-technical ine statementChll pl7Notes to the accountsCh8 p30ObiectivesCh1p4,8-17ObsolescenceCh9 p2Ch68Offer for sale by tenderCh6 p8-9Offer for subscriptionCh6 p9Operating profit……Ch8p16Opportunity costCh17 p19-20OptionsCh4 p30Ch5p10-11Ordinary sharesCh4 p15-20Outstanding claims reserveChll p19OverdraftCh2 p20The Actuarial Education CompanyIFE: 2009 ExaminationsCT2: IndaIle of a share……Ch4p16PartnersPayback periodChl7p15-16Payout ratioCh13 p9Personal taxationCh3 p3-7PlacingCh6 ploPreference sharesh4p20-25Ch13 p7-8Probability treesCh8p2931Profit marginChl3p19-21Ch8Prudence conceptCh7pQQualified opinionCh7 p15Quick ratiCh13 p24QuotationRRealisation conceptCh7 p21Receipts/Costs ratioChI7 p21Reducing balance methodReinsuranceChll pI8Required rate of return on a projectChl8 p3-10Retained earningsCh8 p7h9 pllChIo p5Ch16 pReturn on capital employedCh13 p16-19Revaluation of assetsCh7 plCh8p6,7,17-18Ch14 pRevaluation reserveCh9 p9-10Revenue accountChll p15Rights issueCh6p15-24Chl pllRisk analysisCh8p11-23Risk identificationChl8p13-17Risk matrixCh8p1417Risk mitigationChl8p33-34Risk-free returnChI5 p14C lFE: 2009 Examinationshe Actuarial Education CompanyCT2: IndexPage 7cenario testingCh17p23-24hl8p24-26Scrip dividendsCh16p2425Scrip issueCh6p2430Sensitivity testingChl7p22-23are buvbacChl6p25-26Share capitaCh8 p7Ch9 p8Share premium accountCh9Shareholders'equity ratioCh12 pl7Shareholders’fundCh8 p7Chll p19Shareholder value analysisCh17 p1215Simulation.Ch17p2226Sole traderSpecific riskCh5p18-19Chl8 p6, 11ponsor's criteriaCh17 p4-5StakeholdersChStatement of changes in equityCh8 p28Ch10 p12Stochastic modellingCh18p2426Stock(inventory)turnover ratioCh13p25-26Stock valuationCh14p2,4Straight line basisCh917p17-18SubiJectivityCh14 p4-5Subordinated debth4p10Subsidiary panyChll p2-11Systematic riskChl5p19-21Tangible assetCh8 p4Taper relieCh3 p12Taxation and gearingChl6p15-19Taxation on expenditureCh3 p15Technical accountChll p16Technical provisionsChIl p18-19Theoretical ex-rights priceCh6 pl7The Actuarial Education CompanyIFE: 2009 Examinations8CT2: IndTrade payables(creditorsCh8 p8Trade receivables(debtors)Ch8 pTrial balanceCh10 p26Trust deedCh4 p5UnderwritingCh6p6,p11-12Unexpired risk reserveChll p19Users of accounting informationCh7 p24arranth4p29-30Weighted average cost of capitalCalculationChl5 p32DefinitionCh15 p3-5Discount rateChl p4-5Ch15Theoretical backgroundCh1513Window dressingCh14Working capitalCh 8C lFE: 2009 Examinationshe Actuarial Education CompanyCT2-01: The key principles of financeChapter 1he key principles of financeSyllabus objectives(ii) Demonstrate an awareness of the key principles offinanceOutline the relationship between finance and the real resources and objectivesof an organisationOutline the relationship between the stakeholders in an organisation(including3 Outline the role and effects of the capital marketsOutline agency theory.5 Outline the theory of the maximisation of shareholder wealthIntroductionThis chapter introduces the basic ideas relating to the theory of corporate financeSection 1 discusses the two key decisions relating to the financing of a panysoperations, namely the capital budgeting decision(what to invest in) and the financingdecision(how to finance that investmentSection 2 considers business objectives. A pany is a plex organisation withmany interested parties or stakeholders, eg shareholders, managers, employees. Eachgroup has its own set of objectives and these objectives might conflict with those ofother groups. Agency theory considers these plex relationships and conflicts ointerest(and how to avoid them). This section also considers the role of informationThe Actuarial Education Company@IFE: 2009 ExaminationsPage 2CT2-01: The key principles of financeSection 3 is concerned with the maximisation of shareholder wealth in the face of thedifferent needs and objectives of the shareholders of a pany. It suggests that,ultimately, theompanys financial manager should be to increase the marketvalue of each shareholder's stake in the panyFinally, Section 4 describes the role of capital markets in providing information tomonitor the performance of the financial manager and to assist the financial managerwhen making decisionsYou might find this chapter quite difficult on first reading, but it is a very usefulintroduction to the course. You might want to re-read this chapter as you progressthrough the course, and, in particular, when you have finished the courseThe rest of the course explores financial management further. In the other chapters ofPart 1 of the course we study the ways in which panies are set up, some of the generaloncepts of taxation and the principal forms of financial assets. In Parts 2 and 3 of thecourse we consider how pany accounts are drawn up and how we can use accountingnformation to make useful analyses. In Part 4 of the course we study the capitalbudgeting decision and the financing decision in more detaila The examination is likely to test your understanding of the role of the financial manager,2 the objectives of stakeholders, agency theory and the role of capital marketsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of finance1 Introduction to finance1.1 Finance and the real resources of an organisationQuestion 1.1If you were to set up a new business manufacturing pine furniture, what resources wouldou need?To set up any business, you would need a variety of real assets. By real assets, we meanthe assets that are used by the pany in its normal line of business to generate profitsWe use the term real assets to distinguish them from financial assets such as shares orbonds. In order to carry on business, panies need to employ real assetsboth tangible and intangible. Tangible assets are assets that physically exist (egmachinery and buildings)whereas intangible assets are assets that do not (eg goodwill,trademarks and brand names)QQuestion 1.2How would you raise the finance to set up your new business?To acquire such assets, the pany must raise finance by issuing financialassets such as shares or bonds. We will study the various ways a business can beorganised in Chapter 2 and the various forms of finance in Chapter 2 and chapter 4Thus the financial manager (who is responsible for the major investment andfinancing decisions) stands betweenthe firm s operations(ie the purchase of real assets, which are then used by thefirm to undertakegenerate profits)andthe financial markets(where investors hold the financial assets issued bythe firm to obtain money)The role of the financial manager as the link between the firm's operations and the@IFE: 2009 ExaminationsPage 4CT2-01: The key principles of finance(investors holdingfinancial assets)selling financialcash returnedto investorfinancing decisions)cash used topurchase realash generatedby operationsFirms operationsportfolio of realFigure 1: The role of the financial manager1.2 Finance and the organisation s objectivesMost panies aim to increase the value of their shares by investing in profitableprojects and raising the finance in a cost-effective wayFinance involves two basic issuesWhat real assets should the firm invest in? (the investment or capitalbudgeting decision)2. How should the cash for the investment be raised? (the financingdecision)Firms use real assets to undertake projects-a firm can essentially be thought of simplas a collection of projects. These projects generate revenues and incur costs. The aimof the firm should be to undertake those projects for which the revenues exceed thecosts in order to generate profits on behalf of the owners of the firm- typically thhareholders. The capital budgeting decision considers the choice of projects, and hencereal assets. in which the firms should investC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of financePage 5In practice, the capital budgeting decision is often plicated by the fact thatthere may be more than one apparently profitable project between which toit is very difficult to estimate the future profitability of a projectThe typical project requires a significant expenditure prior to the receipt of the firstrevenues. In addition, it may be several years before ining revenues first exceedoutgoing costs and so the project bees profitable. a net investment will therefore berequired to get the project off the ground. The financing decision considers how best toraise the required finance. For example, should the finance be raised by issuing shares(known as equity finance) or by borrowing(known as debt finance)?We shall examine the organisation's objectives further in Section 21.3 Responsibilities for financial decisionsRemember that the two main questions for the financial manager areWhat real assets should the firm invest in?How should the cash for the investment be raised?The first question is normally the remit of a controller or, in many instances, theChief Financial Officer(CFO)However, capital budgeting decisions will be tied into plans for productdevelopment, production and marketing and so will involve managers fromthese areas( as well as any staff specialising in corporate planningThe second question is the responsibility of the treasurer who:ooks after the pany 's cashraises new capital andmaintains relationships with banks shareholders and other investorsTypically, the CFo will report directly to the Chief Executive Officer whilst thetreasurer will report to the CFO. In practice, the controller/CFO and the treasurer aresometimes the same individualResponsibility for financial issues will, ultimately, rest(by law or custom) withthe board of directors. In practice, boards usually delegate decisions for smallor medium-sized matters. However, responsibility for large financial decisions israrely delegated. We shall examine this further in Section 2The Actuarial Education Company@IFE: 2009 ExaminationsPage 6CT2-01: The key principles of finance1.4 The importance of capital budgetingThe importance of capital budgeting is due to the plexity of the analysisinvolved and the cost of mistaken decisions. It is difficult to project the prospecti'from a particular project with any great confidence. Furtherplications arise when allowing for different possible scenarios, incorporatingoptions into the analysis and discounting the cashflowsInvestment in working capital(such as stock) is largely routine and involves fewplications or risksInvestment in fixed capital,(such as premises, machinery and vehicles) however,often involves plex choices betweenalternative capital assets, each with various advantages and disadvantagesdates of mencement andmethods of financing -eg bank loan, issuing debt, issuing equityThese choices are both plex and critical, given the scope for(and very highcost of)erroneous decisions. Moreover, fixed capital outlays often have aserious bearing on the direction and pace of a firm's growth As such, theydetermine the opportunities open to a firm and the directions in which it canmoveThis is because fixed capital choices can involve the mitment of large sums ofmoney for long periods of time1.5 Financial analysisrogress in management depends on applying logic to experiences, to known orassumed facts in order to enlarge the area of understanding. Investmentdecisions are no exception. Even where it is impossible for financial analysis toimprove the actual fortunes of a particular project, it may nevertheless be able todelineate the risks involved in the projecthighlight the salient factors- ie those that lead to the greatest uncertaintypossibly suggest methods by which these risks might be reduced-wediscuss some methods of risk mitigation in Chapter 18More generally, it may provide greater insight on which to base informed and sensiblenvestment decisionsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of financePage7Financial analysis in capital budgeting involves bringing together estimates andideas from a variety of disciplines-marketing, technology, accounting, tax, lawin order to reveal their financial implicationsAs its name suggests, financial analysis in this context simply means analysing thefinancial implications of different possible courses of action. An in-depth financialanalysis of a project may require the input of experts from each of several differentdisciplines such as those listed aboveUltimately, the problems of capital budgeting in any enterprise are both financialand political. Leaving the investment appraisal of a project to be conducted bythe very people who are most concerned to see the project accepted thedepartment primarily interested in the project is to expect impossibleobjectivityIn other words, all decisions are ultimately made by human beings who are not alwaysimpartial and objectiveThe use of a specialist finance function is an attempt to enforce impartiality andrealism. However, the possible downside of this is that the finance function may lackspecialist knowledge of the particular project under considerationQuestion 1.3What is the role of financial management in an organisation? Why is it important?Why is it difficult?The Actuarial Education Company@IFE: 2009 ExaminationsPage 8CT2-01: The key principles of finance2 Business objectivesWe assumed in Section I that panies aim to increase the value of their shares. Weassume this because most businesses are owned by shareholders, who, we assume, areinterested in maximising the value of their investments in sharesThe extent to which this is true in reality depends onthe extent to which the shareholders control the businessthe extent to which other stakeholders are consideredWe shall consider the various interest groups(ie stakeholders)in a business and willconsider the possibility of conflicting objectives. We will then move on to consider theways in which these conflicts are managed2.1 The stakeholdersThere are many groups involved in running a pany: shareholders, managers,employees, lenders, customers, suppliers, the government. We must consider theirinterests and their roleShareholdersWe shall study the various ways of organising a business in Chapter 2, but we willbriefly examine a typical pany structurehareholdersBoard of directorsGeneral managersThe shareholders own the pany and elect the board of Directors to run the panyon their behalf. Sometimes the directors run the pany themselves, but quite oftenthey hire general managers, who are not shareholders but who are experts in their fieldsto run the panyC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of financePage 9Ultimate responsibility for financial decisions within a pany will usually liewith the directors. The directors are acting on behalf of the ultimateshareholders who elected them). In practice, they will often delegateoperational decision making to the executives, while retaining control ofstrategic issuesThis is sometimes known as" the divorce of ownership from controlSuch separation of ownership and management has advantages- freedom forownership to change without affecting operational activities, freedom to hireprofessional managers but also disadvantages if the interests of the ownersand managers divergeQuestion 1.4What are the objectives of shareholders?Other stakeholdersQQuestion 1.5Give examples of objectives ofmanagers(ii banks and other lenders(ii employeecustomers(v) government2.2 Conflicting objectivesShareholders and managersThe scope for conflict between owners and managers is evident - managersmay be motivated by objectives which are at variance with the desires(andinterests) of the shareholdersThe Actuarial Education Company@IFE: 2009 ExaminationsCT2-01: The key principles of financeFor example, the main objective of shareholders will normally be to receive a highreturn on their investment in the pany. In contrast, some managers might insteadwish to pursue projects of interest over more profitable projects; to take over otherpanies and so gain control of as large a business empire as possible; to have a morleisurely or luxurious working lifestyle; or to aim for a satisfactory return rather than amaximum returnProviders of financeOf particular interest is the potential for conflict between providers of financenotably lenders (such as banks and bondholders)and the providers of equitycapital (the shareholders)For example, a pany's shareholders may be keener to see the pany invest in apotentially high risk and high return project than are its lenders. This is because it is theshareholders who stand to benefit should the project prove successful, whereas thelenders have no particular interest in upside profits- they simply wish to ensure thatthey receive the promised interest and capital paymentsFundamentally, this can be characterised as the difference between the lendersshort-term desire for security and the shareholders'long-term interest in thedevelopment of the panyThis may be the case if the pany is in financial difficulty. The shareholders maythen be very keen to undertake a risky project as a last-ditch attempt to turn the panyaround, whereas lenders may not wish to see their capital placed in even more jeopardyThus, it is difficult for the management to simultaneously satisfy the preferences of bothAt times, however, the interests of different sub-groups of financiers maydiverge, so that different classes of lenders or shareholders may have different interestsQuestion 1.6Give examples of other conflicts that may ariseC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of financePage 112. 3 Ways of managing conflictA pany prises a number of stakeholders, each with its own set of objectivesSome of these objectives coincide, but others conflict. One theory that tries to explainthese plex relationships and conflicting objectives within an organisation is agencytheoryAgency theoryAgency theory which considers the relationship between a principal and anagent of that principal, includes issues such as the nature of the agency costsconflicts of interest (and how to avoid them) and how agents may be motivatedand incentivisedConsider the relationship between the shareholders and the management. Theshareholders are the principals who employ the management as the agents to run thepany on their behalf. Divergence of interests leads to the possibility of conflicts ofinterestSuch conflicts are referred to as principal-agent problems, and give rise toagency costs. These include the costs associated with monitoring the actionsof others and seeking to influence their actionsn practice, the agency costs incurred by the shareholders are usually defined as the sumof three different ponent costs, namely:those incurred in monitoring the managers2. those incurred in seeking to influence the actions of managers3. those incurred because the managers do not act in the owners'best interestsThere are two factors that encourage managers to operate in the interests of theshareholders: job security and remuneration packages. Managers do not want to losetheir jobs, nor their reputations. Many managers receive bonuses based on thepanys earnings or the share priceIf the shareholders feel that the pany is underperforming they can elect a new boardof directors, which, in turn, will probably appoint a new management teamAlternatively, shareholders might express their disapproval by selling their shares. Ifsufficient shareholders do this, then the share price falls. If the pany isunderperforming and the share price falls, the pany is vulnerable to a take-over bidThe management team is likely to be replaced by one that will do what is necessary tomaximise shareholder valueThe Actuarial Education Company@IFE: 2009 ExaminationsPage 12CT2-01: The key principles of financeConflicts of interest may equally arise between other stakeholdersmanagement, other employees, customers, suppliers, pensioners, and the stateFor example, the pany's management (principals) may wish to motivate theemployees (agents) to work hard so that the panys profits are high and themanagement receive large profit-related bonuses. Conversely, the employees may wishto have an easy time at workNote that the panys managers may be viewed as agents when managing thepany on behalf of its owners, whereas they may be viewed as principals whenemploying more junior staff to actually carry out the day-to-day workThe role of informationSuch problems may be easier to resolve if all parties share the same insightsinto the fortunes of the pany. However, information asymmetries will oftenexist between the various classes of stakeholderFor example, the decision to increase a dividend payment is likely to lead to an increasein the share price as investors read this new information from managers and concludethat the management is confident of future earnings, whether or not this is in fact soSimilarly, the employees of a pany may demand large salary increases in responseto the previous year's high profits. At the same time the financial manager may bereluctant to grant large increases because he knows that the firm is unlikely to sustainthe current level of profits in the face of proposed tax and regulatory changesIn some countries, eg Germany and Scandinavia, power-sharing structures exist thatallow employees to have a role in the running of the business, eg worker directors. TheSocial Chapter of the Maastricht Treaty of the European Union promotes theestablishment of works Councils. These measures make more information availableand aim to create a better understanding between stakeholdersHowever, keeping all stakeholders informed is difficult. Company decision-makingoften involves sensitive business information and the need to keep it from mercialrivals also restricts the ability to municate it to stakeholdersa possible advantage of private debt and venture capital equity is that the small numberof investors involved will often be much better informed about the issuing panythan is the case where large numbers of investors hold small volumes of publicly quotedsecuritiesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of financePage 13The role of agreementsWritten agreements between the various classes of stakeholder may specify keyaspects of the relationship between them, but cannot realistically cover allpossible future eventualities. Contracts that do not cover all possible futureeventualities- ie the great majority of contracts in practice- are sometimes referred toas inplete contracts. Such agreements therefore need to be supplemented byless formal understandings and arrangementsContractual theory views a firm as a network of contracts, actual and implicitwhich specify the roles of the various participants in the organisation(workers,managers, owners, lenders, etc)and define their rights, obligations and pay-offsunder various conditions. For example, workers will expect an employment contractbanks will expect a loan agreement setting out details of the rate of interest andrepayments datesMost participants bargain for limited risk and fixed pay-offs, whereas the firmowners are liable for any residual risk(and thus hold a residual claim on anyassets and earnings of the firm that remain after covering costs)As we have seen, there are, however, potential conflicts. One such is between afirm's owners and its creditors. If managers substantially alter the riskiness of afirm's product-market investment activities, this will benefit shareholders greatlyif the investments are successful). However, risky investments that fail willreduce the security of debt holders and reduce debt values. If a firm does notgive strong assurances to debt holders that investment policies will not bechanged to their disadvantage, it must pay interest rates high enough topensate debt holders against the possibility of such adverse policychanges. In other words, the contracts drawn up must take into account, as far aspossible, the various conditions that could face the firm and the reaction of the firm tothose conditions. In this way, the stakeholders will be aware, as far as possible, of therisks they are takingSocial responsibility must also be considered. Efficient, well-managedoperations(relative to consumer demand patterns) lead to new products, newtechnologies and greater employment. But firms must take into account theeffects of their policies and actions on society as a whole the expectations ofworkers, consumers and various interest groups create other dimensions of theexternal environment that firms must respond to. 'Externalities(such aspollution, product safety and job security) must be considered when formulatingpolicy. Some of these expectations are embodied in law, eg health and safety at workemployment protection, consumer protection, environmental protection. Beyond theselaws, there are unwritten, implicit rules of behaviour. Companies'reputations can beseriously damaged if they are found to be untrustworthy or thought to be unethical, andthere can be serious consequences for the share priceThe Actuarial Education Company@IFE: 2009 ExaminationsPage 14CT2-01: The key principles of finance2.4 Business objectives: a re-statementIndustry and government should co-operate in establishing rules for corporatebehaviour so that firms strive to maximise shareholder wealth within externalconstraintsQuestion 1.7When are agency costs incurred?Question 1.8How might the interests of a pany 's management be aligned with those of theshareholders?We will now examine the objective of maximising shareholder wealth in detailC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of financePage 153 The maximisation of shareholder wealth3. 1 The goal of the financial managerMost modern organisations will have many thousands, if not millions, ofindividual shareholders. Here we have in mind publicly owned panies. Privatelyowned panies will typically have a much smaller number of shareholders, whilst asole trader is the single owner of a businessThe needs(and objectives)of these shareholders will vary according to factorssuch asattitude towards risktime preference and consumption needs- ie are investment returns requirednow or some time in the future?balance between the need for ine and for capital growth- ie do theshareholders want a regular dividend from their shares or are they interested inbuying and selling shares to make a capital gain?tax position -eg allowances before paying tax and marginal rates of tax. Sincedividends are taxed differently from capital gains, this might affect whether theshareholder would prefer dividend or capital gainHow can managers and directors, acting as agents for the ultimate owners,satisfy the different desires of these owners? Indeed, how can they even knowwhat these desires are? Whilst in theory they could ask the shareholders, in practiceit would be very costly and time-consuming to do soLuckily, there is a mechanism that enables this conundrum to be solved -themarket. Provided that a free, petitive, capital market exists, (see Section 4)shareholders can choose their investments to meet their needs for cashflowrisk and so on. If we assume that all shareholders seek to be as rich as possible(ie that they seek to maximise current worth then the goal of the financialmanager is simply stated: to increase the market value of each shareholder'sstake in the firmIn this context, "financial manager"refers to anyone responsible for significantinvestment and financial decisions within the pany. The aim of each panysfinancial manager(s) is therefore simply to increase the price of the panys shares,by undertaking profitable and appropriately financed investment opportunitiesInvestors can then choose which shares to include within their investment portfolios soas to best meet their own particular objectivesThe Actuarial Education Company@IFE: 2009 ExaminationsCT2-01: The key principles of finance3. 2 The opportunity cost of capitalThis goal can be further refined to provide an operational tool for financialmanagement. Any operational decision will be reflected in a pattern of futurecashflows(positive and negativerm can essentially be thought of as a collection of projects, so any project canlikewise be thought of in terms of the set of cashflows that it generates, For example, ifa pany invests in new technology, it will incur negative cashflows from the purchaseof the new equipment, the expense of training the staff and the cost of developing andimplementing the new technology; and positive cashflows as new revenue is generatedfrom the new investment. There will probably be a net cash outflow in the early yearsas the equipment is purchased and implemented and revenue is low, and a net cashinflow in later years as revenue is earned and running costs are reduced as a result of thenew technologyWhen analysing an investment project, the pany must estimate all future cashflowstime value of money and discount the future cashflows to the present value unt of theSince cashflows are taking place in the future, the pany should take account of theQQuestion 1.9a project costs f1. 5 million, and is expected to bring in a net cashflow of f500,000 eachyear for the next 4 years. If the discount rate is 10%, is this project worth doing?By discounting the cashflows at an appropriate rate of interest, we can establishthe net present value of any opportunity. If we use the(opportunity)cost ofcapital as the rate at which future cashflows are discounted then allopportunities that display a positive net present value will add to the currentvalue of shareholders'wealth Opportunities that display a negative presentvalue are"value destroying"and should be avoidedQuestion 1. 10display a positive net present value when calculated at theompany's(opportunity) cost of capital add to the current value of shareholderswealthOnce again, the market enables us to identify the appropriate cost of capital touse in decision making -it is the rate of return offered by equivalent investmentalternatives in the capital market -ie the rate foregone by investing in theproject rather than investing in securities.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of financePage 17This is because the shareholders could easily take their money and invest it elsewhereeg in the securities issued by other paniesThus, we need to assess opportunities from the point of view of theshareholders (and, hence, the alternative uses that they could put their capitato) rather than simply asking whether the return on a project is greater than thecost of borrowing the funds needed to finance it. The latter approach mayenable us to increase the value of the pany(in accounting terms)but willnot maximise its value in the eyes of the shareholders- and as we discussedabove, the aim of the financial manager should be to maximise the wealth of theshareholdersNote also the stipulation that we need to consider the rate of return offered byequivalent investment alternatives. Specifically, we need to consider the risksassociated with the project, as well as the returns, to ensure that we areparing like with like. This suggests that in practice we should consider the risk andreturn characteristics of alternative investment opportunities in closely related industrialQuestion 1.11Why do we need to consider the risks associated with the project when determining thecost of capital, as well as the returns, to ensure that we are paring like with like?Question 1. 12(i) What is the objective of financial managers?(i) How can this objective be refined for operational use?The Actuarial Education Company@IFE: 2009 ExaminationsCT2-01: The key principles of finance4 The capital marketsThe capital markets are the markets in long-term finance for panies, such as theshares(or stock) market and the bond market. These markets provide a great deal ofimportant information. This information will be used firstly, to monitor theperformance of the financial manager and secondly, to assist the financial managerwhen making decisionsFor large, publicly quoted panies, the stock market serves as a performancemonitor. While share prices may react to the general economy or industry-widefactors, the basic ponent of the share price is the market,'s perception of theparticular firm's current and expected future performance. If managers are notperforming effectively, relative to the potential of the assets under their control,it will not be long before this is reflected in a lower share price. This may makethe firm a bargain for a corporate acquirer and a take-over bid will be madeBusiness organisations are, therefore, directly and measurably subject to thedisciplines of the financial markets. These markets are continuouslydetermining the valuations of business firms securities, thereby providingmeasures of the firms'performance. The presence of the capital marketscontinuous assessment therefore stimulates efficiency and provides incentivesto business managers to improve their performanceThe financial markets also provide useful information for the financial manager whenmaking decisions on sources of finance and investment projectsKey effects of the capital markets on a firms decisions includeSound investment decisions require accurate measurement of the cost ofcapitalLimitations in the supply of capital focus attention on methods of raisingfiMergers and take-overs create threats and opportunities to be exploitedExternalities"require managers to determine the appropriate role oforganisations.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of financeQuestion 1.13What information does the capital market provide(i) to monitor the financial manager?(ii to help the financial manager make decisions?The Actuarial Education Company@IFE: 2009 ExaminationsCT2-01: The key principles of financeThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of financePage 21Chapter 1 SummaryIntroductionFinance involves two basic issuesWhat real assets should the firm invest in?(the capital budgeting decision2. How should the cash for the investment be raised?( the financing decisionThe main parties involved in financing decisions are the treasurer, the controller, the ChiefFinancial Officer and the board of directorsCapital budgeting is important because the costs of mistakes are high. It is very difficultbecause there are often many options to assess and future cashflows are uncertainThere are many groups of stakeholders in an organisation, each with its own objectivesThese objectives may conflict. This causes problems when one group is responsible fortaking decisions on behalf of others. The directors of a pany make strategic decisionsseparation of ownership and management can lead to principal-agent problems andagency costs if the interests of the owners and managers divergeConflicts of interest may also arise between other stakeholders in a business, notablybetween lenders and the providers of equity capital, and may be reinforced byetries. Agency theory considers issues such asagency costs, conflicts of interest (and how to avoid them)and how agents may bemotivated and incentivisedThe Actuarial Education Company@IFE: 2009 ExaminationsCT2-01: The key principles of financeThe maximisation of shareholder wealthThe needs(and objectives )of shareholders will vary according to factors such aattitude towards risktime preference and consumption needsbalance between the need for ine and for capital growthtax positionThe goal of the financial manager should be to increase the market value of eachshareholder's stake in the firm. Opportunities that display a positive net present valuebased on the pany's cost of capital will add to the current value of shareholderswealth and should therefore be undertakenCapital marketsCapital markets are the markets in long-term capital, such as the share(or stock) marketand the bond market. The capital market provides informationerformance of the financial managers and also to assist the financial managers whenmaking financial decisionsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of financePage 23Chapter 1 SolutionsSolution 1.1To set up your new business, you would need fixed assets or fixed capital such aspremises, machinery, tools, puters etc, which will last for many years, as well asworking capital such as stocks of wood, nails, varnish etc, which will be used up inproduction and soldSolution 1.2You might contribute some of your own savings to the business; you might ask friendsand family to contribute their savings; and/or you might ask the bank for a loan. If youa pany, you would sell shares. To help you buy your stocks of materialsyou might ask suppliers to give you creditpartnership, pany)in Chapter 2 and we will look at the various ways of financingthe business in Chapter 2 and chapter 4Solution 1.3Financial management involves making careful choices in the raising of finance(thefinancing decision) and in the investment of this finance in real assets(the capitalbudgeting decision). It is very important because a wrong decision could have veryserious consequences for the business. It is also very difficult because there are oftenmany options to choose from and the outes from any of the options are subject to greatuncertainty. There are many factors to consider and it is important that the financial teamgathers all the available information and examines the options objectively and realisticallySolution 1.4The objectives of the shareholders might beto obtain a regular dividendto make a capital gain, ie to sell the shares for more than they costto maximise the overall return on their investmentThe Actuarial Education Company@IFE: 2009 ExaminationsPage 24CT2-01: The key principles of financeSolution 1.5(i) Managers may aim forbgood benefits, eg perks such as pany cars, long holidaysprestige and powerThey may therefore wish the pany to aim forgrowth(salary and prestige are often related to the size of the firm)stability (and not to take unnecessary risks)a satisfactory level of profit (rather than a maximum level of profit(ii) Banks and other lenders may wish the pany toemain in businessto pay a market rate of return on the borrowed fundsto meet the payment deadlines(ii Employees may wish the pany topay a market rate of pay for the workstay in businesprovide safe working conditionsprovide trainingprovide a variety of benefits such as pensions, holidays etc.(iv) Customers may wish the pany toremain in business(for after-sales service etc)provide goods at reasonable pricesprovide goods of good qualityproduce and market goods ethicallyC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of finance(v) The government may wish the pany toform well so that itperform well so that it provides jobs to as many citizens of the state asact morally and responsibly eg in line with consumer lawSolution 1. 6Other examples of conflicts includeThe shareholders and managers may wish to invest in labour-saving technologybut workers fear the loss of jobs and consumers fear a reduction in qualityShareholders, management and employees wish to expand production on agreenfield site, but the local munity and local government fear a reduction inthe quality of life with greater visual and air pollution and more congestionSolution 1.7Agency costs are incurred whenmanagers (as agents do not attempt to maximise the value of the panyshareholders(as principals )incur costs monitoring the managers and attemptingto influence their actionsSolution 1.8The interests of a pany's management can be aligned with those of the shareholdersby linking the management 's remuneration to the performance of the pany's sharesOne way of doing this is by giving the managers a stake in the equity of the panyeg via a share option schemeThe Actuarial Education Company@IFE: 2009 ExaminationsCT2-01: The key principles of financeSolution 1.9The pany will consider the present value of all future cashflows. f100 now is worthmore than f100 next year because the f100 now could be invested at 10% and be worthf110 next year. The f100 received next year is therefore worth f90.91 nowAssuming earnings are received at the end of each year, the net present value of theproject (in f000)is5005005005001.500+(11)(1.12(1.1)3(1.1)Since the net present value is positive, this project is worth doing. The project will earnat least a 10% returnIf you are doing or have done Course Ctl, you will know a quick way of doing thisSolution 1.10We can think of any pany as consisting of a portfolio of projects, each of whichgenerates an associated stream of (positive and negative) cashflows. If the project yielda rate of return in excess of the cost of capital required to fund it, then the net presentvalue of the associated cashflows must be positive. Undertaking the project willtherefore increase the total net present value of the pany's cashflows. This increasein the value of the pany should in turn be reflected in the market price of thepanys shares and hence the wealth of the shareholdersSolution 1.11We need to consider the risks associated with the project in determining the cost ofcapital because shareholders will typically be concerned with both the risk and returncharacteristics of their investmentsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-01: The key principles of financePage 27Solution 1.12(i) The aim of the financial manager is to increase the market value of eachshareholder's stake in the firm This means the financial manager aims toincrease the pany's share price by undertaking profitable and appropriatelyfinanced investment opportunitiespresent value when discounted at the opportunity cost of caplan a positive net(ii) The financial manager should aim to invest in projects that yieldSolution 1.13(1 The capital market provides information about the panys share price and theprices of the pany's bonds. These are indicators of the financial managersperformance. For example, if shareholders hear bad news about a panysperformance, they are likely to sell their shares and bring about a fall in the shareprice. This might affect managers directly if they own shares in the pany, orindirectly, through the expressed displeasure of the shareholders. So the capitalmarket keeps managers on their toes(i) The capital market provides information on rates of return required fromdifferent types of financial assets such as shares and bonds. This is helpful whenthe manager is contemplating sources of finance. It is also helpful in calculatingthe cost of capital for use as the discount rate when appraising investmentprojectsBy studying the capital market, the financial manager will be able to monitor themarkets reaction to various policies(either of its own pany or others). Forexample, if shareholders think a pany's proposed investment is likely toincrease shareholder wealth, the share price will tend to riseManagers can also monitor the policies and performance of particulapanies. For example, if Company X is buying other panies that areinvolved in a particular line of business, then other such panies will considerthemselves possible targets. A pany that has been performing less well thanthe sector average and/or has lots of cash will be more vulnerable to a take-overbecause the predator will feel that it could make better use of the panysresourcesThe Actuarial Education Company@IFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipPage 1Chapter 2Company ownershipSyllabus objectives(iii) Describe the structure of a joint stock pany and the different methods bywhich it may be financed.Outline the distinctive characteristics of sole traders, partnerships and limitedpanies as business entities4.Discuss the economic advantages and disadvantages of a limited pany as abusiness entiOutline the main differences between a private and public pan6Outline the different types of medium-term panmy financehire purchasecredit saleeasingbank loansDescribe the following types of short-term pany finance.bank overdraftstrade creditfactoringbills of exchangemercial paperThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 2CT2-02: Company ownership0 ntroductionIn this chapter we lay the foundations for much of the work involved in studyingSubject CT2, by looking at how panies are set up and financedWe first look at the different types of business structure used and the legal frameworkwhich business entities are set up, and then at the ways in which limited panies raisemedium-and short-term financeThe structure of this chapter is as followsection1: Types of business entitySection 2Pros and cons of limited paniesection 3: Types of medium-term pany financeSection 4: Types of short-term pany financThe information in this chapter reflects UK examples but similar principles applyin other countriesa In the past, the examination has tested knowledge of business structures and finance, ande the ability to analyse for a particular business the advantages and disadvantages ofdifferent business structures and different methods of financeC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipPage 31 Types of business entityWe shall look at four types of business entitythe sole traderthe partnershipthe limited panythe limited liability partnership1.1 Sole traderA sole trader is a business which is owned by one person and which is not alimited pany. sole traders have unlimited legal liability for their businessdebtsDescriptionMany sole traders are one person operations, such as a window cleaner or a freelancejournalist, where the owner carries out all the work. However, the definition refers onlyto ownership of the business. There are sole traders who have employeesworking for themThe sole trader can decide what to do with the business(eg pass it on to an offspring)The sole trader can draw out money from the business as he or she needs to(assuming thatthere is some moneyLiabilityThe sole trader has unlimited liability. This means that if a customer sues the sole trader(for breach of contract for example), the total personal wealth of the sole trader, includinghis house and bank deposits, would be available to pay off trading liabilitiesLegal and accounting documentationa sole trader will need to fill in a normal ine tax return in respect of the businessHowever, no specific documentation is needed to legally establish this form ofbusiness entityThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 4CT2-02: Company ownership1.2 Partnershipa partnership is a business which is owned by more than one person and is nota limited pany.DescriptionWhen two or more people go into business together, a partnership is formed. Manyprofessional firms such as accountancy firms and actuarial consultancies are partnershipsSome partnerships are large, and may have literally hundreds of partnersThe partnership may be owned in equal or unequal amounts by the partnersUsually all the partners will be involved in the running of the business, but somemay just provide capital and take no part in the day to day operation of thebusiness(such partners are sometimes called"sleeping partners").Most partnerships will strictly control who might be allowed to buy an interest in thepartnershipPartners will draw money from the partnership from time to time. This can be more or(often) less than their share of profits. The internal accounts will show any surplus/deficitin each partner's"capital account"resulting from under or over drawing, and from capital(finance) provided to the partnershipLiabilityThe owners have unlimited liability. all the partners are jointly liable forbusiness debts. They will also be"severally liable", that is, each partner is lito the full extent of his/her personal estate for the deficiencies ofpartnership. This means that each individual partner can be sued separately for theentire debts of the whole business. This explains why businesses which involve ameasure of trust between the business and its clients, such as solicitors and consultingactuaries, are often set up as partnerships. It is a signal that the people running thebusiness are willing to put their own personal wealth behind the firm's obligationsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipPage 5Legal and accounting documentationMost partnerships will have a"partnership agreement "which sets out the rightsof individual partners, such as who can make what decisions and how profits are sharedbetween partners. Strictly, no specific documentation is needed. The partnership will alsoneed to provide accounts so that the Inland revenue can work out each partners liabilityto tax on their share of the partnership's profits. Partners payA new form of partnership was introduced in 2001. The limited partnership is discussedafter we have discussed the limited pany1.3 Limited paniesA limited pany is a business which has a legal identity separate from theowners of the businessDescriptionA limited pany has its own distinct legal identity. It can own or deal in property in itsown right. It can arrange contracts on its own behalf. It can also sue and be sued. Apany can be fined by the court(but not imprisonedAlmost all limited panies are set up by the issue of shares. The owners of thepany are called shareholders. Each shareholder will hold a certificate showinghow many shares they own in the pany. Most shares give the right to vote atpany meetings. The shareholders will appoint directors who areresponsible for the control of the pany on behalf of the shareholders. Thepany is run by managers who carry out the directors' policies on a day to day basiManagers are often elected as directors, in which case they are known as executivedirectors. Directors who are not involved on a daily basis are known as non-executivedirectorsIn most cases, shares in a pany may be purchased and sold without the permission ofthe other shareholders. Shareholders will not generally be actively involved in the runningof the pany. These statements are more true of public limited paprivate limited panies(we discuss these two types of pany in a later section)The Actuarial Education CompanC IFE: 2009 ExaminationsPage 6CT2-02: Company ownershipProfits will be declared each year and a dividend will usually be paid to eachshareholder in proportion to the number of shares they own. It is mon fordividends to be paid in two instalments: an interim payment made halfway through theyear and a final payment at the end of the year once the accounts have been finalised. Thetotal amount of dividends is usually less than the profits for the year, the balance beingretained in the pany on behalf of the shareholders. However, the amount of dividendcan be the same or even greater than the profits(dividends can exceed profits in aparticular year if there are sufficient retained profits from previous years)LiabilityThe owners' liability is limited to the fully paid value of their shares. Shareholdersin a limited pany have their liability limited to the fully paid value of their shares. Sothat, if shares have been issued "partly- paid "then in the event of a liquidationshareholders will only be liable to pay the outstanding instalments. If the sharesare "fully paid", the shareholders have no further liability. If shares have beenissued at a premium to their par value, the whole of this "share premium"ispayable at the outset, even if the shares are issued on a"partly- paid"basis. Ifthe pany bees insolvent, creditors cannot claim further payment from theshareholders personal wealth beyond the fully paid value of their sharesLegal and accounting documentationLimited panies must have a Memorandum of Association and Articles ofAssociationThe Memorandum of Association states how the pany will deal with the outsideworld. It contains information such as the name of the pany, its objectives, ishare capital and the unit size(or "nominal value?")of a share(eg f1, 25p). It must besent to the registrar of Companies before a pany can be formedThe Articles of Association lay down the internal rules by which the directors run thepany and set out the rights of owners of the different classes of share capital. Thecontents include internal arrangements such as voting rights of different classes of sharesrules for electing directors, payment of dividends and winding-up provisionsAll panies must produce audited accounts each yearCompanies pay corporation tax on the profit earned. Employees pay ine tax onwages and salaries earnedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipPage 71.4 Limited liability partnershipsA new corporate identity, the Limited Liability Partnership(LLP), was introducedin the UK in 2001This is a business vehicle that gives the benefits of limited liability whilstretaining other characteristics of a traditional business partnershipDescriptionAny firm consisting of two or more members (note: not partners)engaged in aprofit-making venture, may bee a LLP. Unlike limited panies, there areno directors (or pany secretary)and, of course, no shareholdersThe LLP, as with a limited pany, is a separate legal entity. As a separate legalentity, the LLP is able to enter into contracts, hold property and to continue in existenceregardless of changes in membership. Any third party dealing with a LLP makes acontract with the llp rather than with a memberLiabilityWhilst the LLP itself is responsible for its assets and liabilities, the liability of itsmembers is limited.(As with panies, however, actions may be taken againstindividual members who are found to be negligent or fraudulent in theirdealings.Legal and accounting documentationUnlike a limited pany, a LLP has no Memorandum Articles of AssociationIn general terms, a LLP is governed by the partnership agreement that mayalready be in force within an existing partnership. In the absence of any agreementthe mutual rights and duties will be governed by the default provision contained in theregulationsLike a pany, a LLP has to be registered at Companies House. An incorporationdocument must be submitted and signed by at least two persons, who will bee thefirst members of the LLP. A llp is required to appoint at least two designatedmembers who will be responsible for a number of duties in the running of the LLp suchas the signing and filing of the annual accountsThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 8CT2-02: Company ownershipThe accounting and audit requirements for LLPs will be similar to those for paniesfor example, financial disclosure for third parties dealing with the LLp and disclosure ofearnings of the highest paid member. However, whereas all panies must produceaudited accounts, the annual accounts of a LLP need to be audited only if the turnoverfor a financial year exceeds fl millionA LLP is taxed in the same way that partnerships are taxed. LLPs that do not carryon business as a trade or profession, such an investment pany, are subject tocorporation tax.It is expected that LLPs will prove most attractive to professional firms (such asaccountants and solicitors). The UK has seen a steady flow of partnershipsincorporating as LLPs since the first conversion in 2001, with recent announcementsconfirming that the rate of change is increasing as the LLp model bees more widelyQuestion 2. 1Contrast the different types of liability which are characteristic of the following forms ofbusiness entitysole tradershiplimited panylimited liability partnershipQuestion 2.2Draw up a table to pare a partnership a limited liability partnership and a limitedpany with respect tomain source of financelegal identityliabilitydocumentationdisclosuretaxC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipPage 91.5 Private and public limpanyLimitedin two forms, public limitedes andate limitedpanies. The two forms of pany are very similar. The difference is simply howey register themselves. Itregister as a public limited pany. The legal definitions are set out in the CompaniesAct 1985Public limited panya public limited pany is a pany whose Memorandum states that it is apublic pany and which has an issued share capital of at least E50,000.Thename of a public limited pany must end with the words "public limitedpany or the abbreviation Plc or plc.a public limited pany must also be"correctly registered"with the Registrar ofCompaniesEach issued share must be paid up to at least a quarter of its par value plus the whole ofany premium on itlote that the definition does not have anything to do with whether the pany is ownedby the public sector(ie government) or private sector- although most public paniesare private sector paniesPrivate limited panyD All other limited panies are classed as private limited panies. A privatelimited pany's name must end with the word "limited". a private limitedpany is not allowed to offer its shares to the public.Listed paniess a requirement of the Stock Exchange that a pany that wants to have afull Stock Exchange listing must be a public limited pany. It is possible tehave an unlisted public pany, but in practice most panies willgo public"andobtain a listing on the Stock Exchange, allowing widespread dealing in the pany'sshares, at the same time. (We will look at how panies obtain a Stock Exchange listinglater in the course.)The Actuarial Education CompanC IFE: 2009 ExaminationsCT2-02: Company ownershipConsequently, most public panies are large panies whose shares are held by manydifferent shareholders who take no part in the panies'day to day operations. Privatepanies are more typically small panies with a narrow range of shareholders, oftenbeing" family run"businessesess mon types of panyThe following types of pany also exist in the UKCompanies limited by guarantee. Each member's liability is limited to theamount they have guaranteed, eg t1, 000Companies established by royal CharterClose pany. A pany under the control of five or fewer people. Bothprivate and public limited panies could be closeC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownership2 Pros and cons of limited panies2. 1 Advantages of limited paniesThe main advantage is that the limited liability makes it easier to raise capitalQuestion 2. 3Why is it easier for a limited liability pany to raise capital than it is for a largepartnershipThis is particularly important in the cases ofBusiness ventures involving a risk of incurring substantial debtsInsurance panies would be a good example of a pany that might notexist without limited liability. (Note that most mutual offices are setlimited panies, albeit without share capitalbusinesses which require large amounts of capital. Most industrialbusinesses need vast amounts of capital. This means that large numbers ofpeople need to provide money. Without limited liability, panies would findit very difficult to raise capital. Few investors would provide capital to apartnership in which they had no day to day controlLimited liability allows large numbers of people to invest small amounts ofmoney with relatively minimal checking of the pany,'s prospects. In turnthis allows investors to diversify their exposure to sectors and to the risk offailureThe pany is owned by a number of shareholders, perhaps very many. In smallpanies, each shareholder might also be an executive director and thus have somecontrol of the pany. This is sometimes called a "tight"shareholding. However, in thecase of public limited panies and quite often in private limited panies too, most othe shareholders take little or no role in the management of the pany this wasdiscussed in Chapter I and is known as the separation of ownership and control (or thedivorce of ownership from control). This has some advantages for the panySeparation of ownership and management allows share ownership tochange without interfering with the operation of the businessIt also allows the firm to hire professional managersThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 12CT2-02: Company ownership2.2 Disadvantages of limited paniesTo the creditorsOnce the pany,'s assets have been exhausted the trade creditors have noway of ensuring payment following a wind-up. Similarly, customers have no way ofensuring that they receive goods and services for which they have pre-paid. Over the lastfew years there have been many stories of panies running into problems because somecustomer panies have been liquidated leaving unpaid bills. Newspapers areparticularly keen on stories of travel panies being liquidated leaving customersstranded overseas or with no holiday at allTo the panyLimited liability allows people to invest in shares without taking an activeinterest in the long-term needs of the pany. The UK Stock Market has oftenbeen accused of"short-termism"-the desire for good short-term share price performanceith little interest in the long-term health of the panyTo the shareholdersThe managers of a pany may have aims which are not in the best interestsof the shareholders(this is known as the "agency problem"as we discussed inChapter 1). An"inefficient" corporate attitude may develop since ownership of thebusiness is divorced from day to day control. With an identity of their own, paniesmay see survivorship, good employment terms for their staff and expansion as goals inthemselves. Managers may use retained profits to fund growth and diversification of thepany, even if the economically most desirable action is for the pany to wind upMany panies seem to pursue sales growth(to increase the directors salaries? )withoutworrying too much about profit maximisation for shareholdersThere is also the problem of "information asymmetriesstakeholders (managers, shareholders and lenders)alhinformation about the value of a real or financial asset. this reinforcesfor proper accounting standards to be observed thentrol thenformation available to interested parties and thus might, in the absence of strictstandards, be able to present the information in a particular light. For example, a fall inprofit might be hidden in order to avert an adverse reaction by the shareholders and thecreditors. We will discuss accounting standards in Chapter 7.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownership2.3 ConclusionIt is no coincidence that the increase in numbers of large, efficient industrial enterprisesoccurred in the second half of the 19th century when the modern concept of limitedliability was introducedLimited liability is usually necessary for a pany to grow beyond the size that onefamily or a small partnership can control(some large professional partnerships are anexception to this). Most of the benefits of economies of scale resulting from moderncapital-intensive production line techniques can thus be attributed to the concept of limitedQuestion 2. 4If you were starting up a new business with a friend, what factors would you considerwhen deciding whether to set up as a partnership or a panyExaminers usually ask a general question about the relative merits of different forms ofbusiness organisation(as above)but sometimes they like to put you in a particularsituation and ask you to think of an appropriate form of business organisation for thatituation. For exampleHarold and Maude are in the process of setting up a risk management consultantExplain the relative advantages and disadvantages of setting up this business as apartnership and as a limited pany. " (Septemberadapted)Make sure you know the relevant points, but always relate them to the particularbusiness. Much of the time, you make general points but use the names given in thequestion! In this case, you would particularly consider: how well Harold and Maudeknow each other(can they trust each other in a partnership? ) whether or not they needto display mitment in the business to gain clients trust; and whether or not they willneed the protection of limited liability (particularly if one contributes more than anotherto the business and therefore has more to loseThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 14CT2-02: Company ownership3 Medium-term pany finance3.1 IntroductionAll organisations need capital to finance premises, equipment and operations.The main sources of long-term finance-debt and equity are considered inChapter 4. Here we will consider the sources of medium- and short-termnanceIn this section we look at medium-term finance and in the next section we look at shortterm types of finance. Medium-term finance typically has a term of over one year, but lessthan about five years. Short-term finance typically has a term of less than one yearThe four forms of medium-term finance we look at arehire purchasecredit salebank loans3.2 Hire purchaseHire purchase arrangements are used both for consumers (eg buying a new car orputer) and for mercial transactions(eg buying a new tractor)ED A hire purchase agreement is an agreement to hire goods for a period of timemaking regular rental payments and then to buy the goods at the end of therental period. Legal ownership passes to the buyer only when the final paymentis madeIn most cases, the good is bought by making the last of the regular series of payments. Nospecial payment is neededThe payments can be thought of as being partly payment for the good, and partly interestIf the buyer fails to make the payments due under the hire purchase agreement,the seller can take back the good (subject to a few legal nicetiesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipExampleMrs grass is buying a lawnmower. Her local garden centre has one on sale for f225which she can pay for in cash. Alternatively, she can pay a deposit of t50 plus 12monthly payments of f20 each under a hire purchase agreementNote that the total cost of using the hire purchase agreement to buy the lawn mowerE 290. The extra f65 she has to pay can be considered as interestMrs Grass uses the hire purchase agreement to take the lawn mower home and cut herntly failspurchase agreement. The garden centre therefore reclaims the lawn mower and so endsup with a second hand lawn mower for sale. Mrs Grass ends up with long grassCompanies will often use hire purchase agreements to buy machines and puterequipment. It is important from the seller's point of view that the term of the hirepurchase agreement is a lot less than the useful life of the good. If this is not the case, thebuyer might decide not to make the final payments when the good is worthless3. 3 Credit saleCredit sales are similar to hire purchase agreements, with the crucial difference that legalownership passes from the seller to the buyer at the start of the agreementA credit sale is a normal sale of a good together with an agreement that paymentwill be made by a series of regular instalments over a set period of time. Legalownership passes to the buyer at outset.Again, the payments under a credit sale can be thought of as part interest and part paymentfor the good being boughtThe seller cannot reclaim the goods even if the buyer defaults. All that the sellercan do is to sue for payment through the courts as with any other debt. The sellerhas no more legal right over the good sold than over any of the defaulting customers otherpossessions. Not surprisingly, hire purchase agreements are more popular with sellersparticularly when dealing with consumers of dubious creditworthinessThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 16CT2-02: Company ownershipExampleMrs grass is fed up with having long grass and wants to buy another lawnmower. Sheguises herself and goes down to her local garden centre. They have a hardly usedsecond-hand lawn mower on sale for f140 which she can pay for in cashAlternatively, she can pay a deposit of f75 plus 12 monthly payments of f10 each undera credit sale agreementThe extra f55 she has to pay can be considered as interestMrs grass uses the credit sale agreement takes the lawn mower home and gives herlawn a long overdue cut. When she subsequently fails to make the payments under thecredit sale agreement she gets lots of nasty letters from the garden centre threatening totake her to court. Eventually she is taken to court and ordered to pay the money owingWhen she refuses the bailiffs e round and take away her television which is sold andthe proceeds given to the garden centre. So, rather than watching the television, MrsGrass sunbathes on her neatly kept lawnQQuestion 2.5Compare and contrast a credit sale agreement with a hire purchase agreement3.4 LeasingLeasing is used by panies to obtain the use of machines, property and vehicles. Thekey distinction between leasing and credit sales or hire purchase agreements is that legalownership does not change hands at all. There is no sale and no purchase. A lease issimply an agreement for the "lessee" to rent from the"lessorA lease is an agreement where the owner of an asset gives the lessee the rightto use the asset over a period of time, in return for a regular series of payments.Legal ownership does not change handsSometimes, lease agreements do give the lessee the option to buy the asset at the end ofthe lease period. This then blurs the distinction between a lease and a hire purchaseagreement, although under a lease the payment made to exercise an option to buy willreflect the remaining value of the asset. Also, the lessee does not have to buy the goods atthe endC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipPage 17There are two types of lease: operating leases and finance leases. The differencehinges on the length of the lease in relation to the expected economic life of the assetOperating leasesUnder an operating lease, the owner of the asset will retain most of the risksassociated with owning the asset. The lease will be for a period substantiallyshorter than the likely life of the assetFinance leasesUnder a finance lease. the lessee takes on most of the risks associated withowning the asset. The lease will be for a period similar to the likely life of theasset. In effect, the lessee is buying the asset outright, but financing the purchase bypaying rent rather than by paying a lump sum up front. the present value of theayments under the agreement is shown in the lessee' s balance sheet twice: asan asset and as a corresponding liability. we will be looking at the workings ofpany balance sheets later in the course.)ExampleThe owner of a gold mine with an expected working life of 15 years leases the mine to amining pany for 3 years. In this case the owner of the gold mine still experiencesthe joy of seeing gold prices rise, and the misery of seeing them fall, because he has anasset which is heavily dependent upon the price of gold. This lease would be classifiedoperating leIf, on the other hand, he had leased the mine for 14/2 years, he would have effectivelysold it. The lease is being used only as a finance arrangement. The owner might be asinterested in whether Norway win the Eurovision Song Contest again as in whahappens to the price of gold. Such a lease is known as a"finance leaseThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-02: Company ownership3.5 Bank loansa bank loan is a form of medium-term borrowing from a bank where the fullamount of the loan is paid into the borrower' s current account, and the borrowerundertakes to make interest payments and capital repayments on the fullamount of the loanBank loans are usually secured on the borrowers assets using a floatingcharge, that is, all the assets of the pany or the individual are assigned assecurity for the loan, although banks do sometimes grant unsecured loans. For a smalbusiness, the owner of the pany may even provide a fixed charge on his house assecurity. Bank loans can be used to buy non-current assets such as machinery andvehiclesThe interest rate is usually variable(although fixed rate bank loans do exist). It mightbe set at a margin above the banks own base rate, or as a margin over a benchmarkinterest rate such as LIBOR ( LIBOR stands for the london Interbank Offered Rate - it isthe rate at which the banks will lend to each other, and is quoted daily in the Ft). IfLIBOR is used, the rate is re-calculated at discrete points in time in line with the particularterm of liBOR which is being usedExampleA pany arranges a f2,000, 000 bank loan to buy a piece of machinery. The interestrate is set as being 3% above 3-month LIBOR. At outset, 3-month LIBOR is 6. 2%(it iscustomary to quote as an annual rate of interest), so the pany pays interest at a rateof 9.2% for the first 3 months. After the first 3 months, 3-month LIBOR is 6.9% pa, sothe pany pays 9.9% for the next 3 months, and so onMost bank loans in the UK are for a period of 7 years or less, although the termsoffered vary. In general, UK banks have been reluctant to lend for longer terms,preferring panies to use loan capital and share capital for longer terms. In the rest ofthe EU, banks are more willing to lend longer term, and loan capital is less importantLoan“ facilities”Over the last decade the range of types of bank loans that are available has widened a lotFor example, loans are available where the borrower can take out the loan ininstalments, giving the bank a few days'notice before each new bit is taken outSuch arrangements are called"loan facilities "because they are a cross between anoverdraft facility(discussed in Section 4) and a traditional bank loan. Interest is onlycharged on the amount outstanding and repayment schedules are more flexibleC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipOther variationsFor large scale borrowing, plex loans are available. For examplemulti-currency loans: where the bank acts as a middle man and arranges toborrow money in whichever currency looks the best value to borrow in. Thebank then swaps the loan into sterling or whatever currency is requiredsyndicated loans: where the loan facility is provided by a group of banksThis would be used where the sums to be borrowed are larger than any one bankwould happily lend on a single projectQuestion 2.6Give some examples of situations where a syndicated loan might be consideredThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-02: Company ownership4 Short-term pany financeIn this section we consider the following types of short-term financebank overdraftsbills of exchangemercial paperThe last two are"securities,"which means that they can be sold from one investor toanother. All other types cannot be traded4.1 Bank overdraftsAn overdraft is a form of short-term borrowing from a bank where the borroris granted a facility to draw money out of a current account such that it beconegative, down to an agreed limit. the borrower pays interest only on theamount by which he or she is actually overdrawn. No explicit capitalrepayments are madeAs with bank loans, overdrafts made to panies are usually secured by afloating charge. Interest rates are almost always variable, often on a daily basis. Theinterest charged on an overdraft will usually be higher than on a loan ofequivalent amount. However, an overdraft is more flexible and the borrower paysinterest only on the amount of the facility that is actually used. The borrower does nothave to use the facilityBanks like the use of overdrafts to be restricted to short-term working capital needs, forexample to cover seasonal variations in a pany's need for finance, eg for buying stockahead of the peak selling period. In practice, many businesses seem to have overdrafts thathave been in existence for long periods of timeOverdraft facilities usually need to be re-negotiated annually. Unlike bank loans, a bankcan demand immediate repayment of an overdraft with no notice. This makes apany that borrows on overdraft for long-term purposes (eg to build a factory)vulnerable to a bank's continuing support. It is often lack of liquidity(ie shortage of cashwith an overdraft being called in that causes business bankruptcy, not fundamental lack ofprofitabilityC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipPage 21Question 2.7Which is likely to be more expensive: a bank loan or a bank overdraft?4.2 Trade creditTrade credit is an agreement between a pany and one of its suppliers to payfor goods or services after they have been suppliedTrade credit is available from almost all suppliers of goods and services to their businesscustomers. Typically, after goods are delivered, the business customer will be sent aninvoice demanding payment within a set period, eg 28 days or 91This usually formspart of a supplier's normal terms of businessIn most cases no explicit interest is charged. In many industries, late payment isso mon that explicit discounts can be negotiated for not using trade credit,in effect giving discounts for"cash on delivery'In practice, businesses often try to pay later than the date stated on the invoice. Suppliersoften have to devote considerable resources to chasing up late payers. Many owners ofsmall businesses plain that they are pushed to the point of bankruptcy by businesscustomers who fail to pay up on timeUsing trade credit to the full is a way for businesses to obtain "free"finance. The problemwith using (or more likely abusing) trade credit is that it can damage a pany'srelationship with its suppliers4.3 FactoringTrade credit can cause problems for the suppliers of goods. Often they will have a higheroverdraft than they would otherwise need. An alternative way of financing the trade creditthat they have to give is to use factoringThere are two types of factoring: " non-recourse factoring"and"recoursefactoring”(or“ invoice discounting")The Actuarial Education CompanC IFE: 2009 ExaminationsCT2-02: Company ownershipNon-recourse factoringNon-recourse factoring is where the supplier sells on its trade debts to a factorin 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 lossesAs wellding invoices to its customers, the supplying pany sends an invoice toits factoring house. The factoring house then immediately pays over a fixed amount, forexample 85%, of the value of the invoices to the supplying pany. The 15% discountwill reflectinterest on the money advanced the customer who has been invoiced will notpay the factoring house for some time whereas the factor has paid the supplyinpany immediatelythe administrative costs of the factoring house: they will have to spend timechasing up unpaid invoicescredit risk: if the customer never pays up, it is the factoring house that loses outUsing a factor gives the supplying pany money earlier than if it had to wait to be paidprotection against bad debts, and an administrative service. However, the factor will wantto get the customers to pay up as soon as possible, so may put excessive pressure on thesupplying pany's customers. This could have a negative effect on the suppliers futurebusiness with these customersRecourse factoringA copy of the invoice is sent to the factor who then gives the supplying pany themoney up front equal to, say, 85% of the invoices it sends out. However, the supplyingpany is still responsible for collecting its debts(so its customers are not contacted bythe factor). When the supplying pany eventually gets paid by a customer, it passes themoney on to the factorThe factor has no control over the debt collection process, so it charges the supplyingpany interest on the 85% of the invoice that it has paid from the date the advance wasmade to the date that the supplying pany gives the factor the moneyC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipThe factor and the supplying pany then settle up by the amountamount advanced interest accrued -amount of invoicebeing paid by the supplying pany to the factor (or vice versa if this amount is negativeas will usually be the case)ExampleCompany r sends out an invoice for f100 to one of its customers. At the same time, itsends a copy of the invoice to its factors, Eezeekash Ltd, in return for the sum of f85Six months later, Company R's customer pays the invoice, and Company R sends theE100 to Eezeekash. During that six-month period, interest of 58.50 has been incurredtheEezeekash settlesthe transaction by sendingf(100-85-8.50)=6.50 to Company rIn this example, the pany received short-term finance in return for an interest chargeof E8.50, which represents the profit made by the factor on the transactionRecourse factoring only provides early payment of invoicesIt is a loan which is secured against the invoices, and has a value whichautomatically fluctuates with the amount that the pany sells. In other wordsthe more invoices the pany sends out, the more finance it receives from the factorCredit risk remains with the original supplier.4.4 Bills of exchangeSuppose that pany S supplies some good or service to pany C on three monthcredit terms (ie C does not need to pay immediately, but agrees to pay s in three monthstime)Rather than just invoicing C, S can draw up a formal bill and ask C to sign it. (S is knownas the“ drawer”’ of the bill and c is known as the“ drawee”or, once C signs,theacceptor”)The Actuarial Education CompanC IFE: 2009 ExaminationsPage 24CT2-02: Company ownershipThe bill that S draws up for C to sign might look like thisPCSSide streetSurreySM6 6SS9/7/07Three months hence, pay to me or my order the sum of four thousand threehundred pounds sterling only(E4, 300To: Company CCoal closeChesterCheshireCH3 3CHSigned(Mr C Collins, director of Company C)Such a bill is known as a" trade bill "or an“‘ acceptance¨”.The reasoning for getting C to accept a bill, rather than just using a normal invoice, is thatS will subsequently be able to sell the bill if it needs cash. Suppose that s needs the cashquickly. It might be able to immediately sell the bill to a discount house (a financialinstitution that specialises in dealing with bills)or a bank which would then be able topresent the bill to C in three months time and so receive the stated payment from CHowever, in most cases a discount house or a bank will not know pany C and will notwant to take on the unknown credit risk. So, before the bill is bought, most trade billshave to be guaranteed by someone. An investment bank will guarantee the bill, so that ifompany C defaults, the investment bank will pay up instead. Once an investment bankhas endorsed the trade bill it bees known as a "bill of exchange "or a"bank bill",, Thecost of getting an investment bank to endorse a bill of exchange depends upon thecreditworthiness ofc( e the first“"name”)of the pany which owes the money and of the accepting bank. rry the nameBills of exchange are known as two name"paper because they caWhere the endorser is an"eligible"bank, the bill is known as an"eligible bill ofexchange". An eligible bank is an investment bank whose endorsed bills of exchangeare eligible to be sold to the bank of englandC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipThe bill of exchange can then be sold on to a discount house or a bank which will pay aprice below the face value of the bill. The discount house will then receive the full facealue on the date when the bill is paid by the acceptor or the accepting house. In the caseof an"eligible bill" the bill of exchange is a very secure investment and so thediscount rate used for this calculation will be very close to the then current rate of discounton Treasury bills(a type of risk-free government security)a bill of exchange(effectively, a claim to the amount owed by a purchaser ofgoods on credit)may be"accepted"by a bank(for a fee. This means that thebank guarantees payment against the bill to whomsoever holds the bill atmaturity the bill can then be sold to raise short-term finance4.5 Commercial paperCommercial paper is a form of short-term borrowing by large panies. From thepanies' perspective, issuing mercial paper is an alternative to overdrafts or shortterm bank loans. a piece of mercial paper might appear as followsOn surrender of this note to the registered office of Company d plc on or after 15 March2008, the holder will be entitled to receive payment of five hundred thousand poundssterling(£500.000DartmouthDevonDDI IDDValid only if the seal of Company D appears hereCommercial paper is a type of bearer document, ie there is no register of holders. Paymentis made to whoever presents the piece of paper at the end of the term. Commercial papeis issued at a discount and later redeemed at its face value. For example, the piece ofmercial paper shown above might have been issued at a price of about #470,000 on1 5th July 2007By buying a new issue of mercial paper, investors are effectively lending money topanies for an agreed period (ranging from 1 week to 1 year). The effective rate ofinterest paid by the borrowing pany will be slightly higher than the equivalent rate ona risk-free investment(such as a Treasury bill). The size of the""margin"over the risk-freerate of interest will depend on the pany' s credit ratingThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-02: Company ownershipCommercial paper is not listed on the stock Exchange but can still be bought andsold quite easily. There is a large market for mercial paper in the US. Euromercial paper also exists, and is traded internationally over the telephone in a similarway to Eurobonds. In the uk, there is Sterling Commercial Paper. Other countries alsohave their own domestic markets for this type of borrowingThese instruments may be described as"single-name". The security is provided only bythe pany issuing the paper(ie borrowing the money). This contrasts with bank billdescribed above which have two names the issuer and the bank that endorses the billCompanies that wish to raise finance by issuing sterling mercial paper haveto meet certain minimum standards. Issuing panies mustbe listed on the London Stock Exchange.issue a statement to confirm that they ply with the requirements ofthe Stock Exchange, and that there have been no adverse changes in thepany,'s circumstances since they last published accounts inaccordance with stock Exchange rulesThe minimum size in which sterling mercial paper can be denominated isE500,000. The total size of an issue is typically about f50m(eg 100 lots of t500, 000)Given that this is only for short-term finance, we are talking about big paniesborrowing large amounts of moneyCommercial paper is a single name form of short-term borrowing used by largepanies. It es in the form of bearer documents for large denominationswhich are issued at a discount and redeemed at par.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipQuestion 2.8(1) What are the advantages and disadvantages of hire purchase agreements andcredit sale agreements from the point of view of the supplier?(ii) State the main distinction between an operating lease and a finance lease(iii State the main distinction between a bank loan and a loan facility(iv) State the main distinction between a loan facility and an overdraft(v) State the main distinction between a credit sale agreement and trade credit(vi) What are the advantages and disadvantages of invoice discounting and non-recourse factoring from the point of view of the supplier?(vii) Describe how a pany raises finance using(a) bills of exchange(b) sterling mercial paperd indicate the most important differences between these two financialInstrumentsExaminers usually ask for descriptions of the main forms of finance and parisonsbetween them. They might also ask you to think about the appropriate form of financefor a particular situation. For example:Mr and Mrs Patterson own a small limited pany. They wish to purchase two vanscosting t12, 000 each. Advise them of three methods of finance which might beappropriate for this purpose. (April 1999)You will probably consider a bank loan, hire purchase and credit sale. Remember to usethe names(the Pattersons)and relate to the items(the vans), eg the vans could be thesecurity for the bank loan to the pattersonsThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-02: Company ownershipThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipChapter 2 SummaryTypes of business entityThere are four main types of business entity: the sole trader, the partnership the limitedpany, and the limited liability partnershipA sole trader is a business which is owned by one person and which is not a limitedpany. Sole traders have unlimited liability for their business debtsA partnership is a business which is owned by more than one person and is not a limitedpany. All the partners are jointly and severally liable for any business debtsA limited pany is a business set up under Companies Act legislation which has alegal identity separate from the owners of the business. A pany is owned by itsshareholders. Their liability is limited to the fully paid value of their sharesA public limited pany is a pany whose Memorandum of Association states thatit is a public pany, and which has an issued share capital of at least E50,000. Publicpanies can apply for a listing on the Stock Exchange.a private limited pany is a pany that is not a public limited pany. Privatepanies'shares cannot be listed on the Stock ExchangeA limited liability partnership(LLp)is owned by its members but has a separate legalidentity. The members benefit from limited liability. The members are free to agreeamongst themselves the relationship between themPros and cons of limited paniesLimited liability makes it easier for a pany to raise capital. This is particularlybusinesses which need to raise large amounts of finance from many peopl tial debts, orimportant for business ventures where there is a risk of incurring substarThe main disadvantage of limited panies is that creditors may not get theirback if the pany is wound up. Also, ownership is often divorced from control oneyThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-02: Company ownershipMedium-and short-term pany financea hire purchase agreement is an agreement firstly to hire a good for a period of timeg regular rental payments, and then to buy the good at the end of the rental periodLegal ownership passes to the buyer only when the final payment is madea credit sale is a normal sale of a good together with an agreement that payment will bemade by a series of regular instalments over a set period of time. Legal ownershippasses to the buyer at outseta lease is an agreement where the owner of an asset gives the lessee the right to use theasset over a period of time, in return for a regular series of payments. Legal ownershipdoes not cha bank loan is a form of medium-term borrowing from a bank where the full amount ofthe loan is paid into the borrowers current account and the borrower undertakes tomake interest payments and capital repayments on the full amount of the loan. a loanfacility is a more flexible form of borrowing from banksAn overdraft is a form of short-term borrowing from a bank where the borrowergranted a facility to draw money out of a current account such that it bees negativeip to an agreed maximum limit. The borrower pays interest only on the amount bywhich he or she is actually overdrawn. No explicit capital repayments are made,although the bankII in the overdraft at any timeTrade credit is an agreement between a pany and one of its suppliers to pay forgoods or services after they have been supplied.Non-recourse factoring occurs when a supplier sells on its trade debts to a factor. Thefactor takes over responsibility for the collection of the debts. Under recoursefactoring, the supplier keeps responsibility for collecting its own debtsa bill of exchange is a negotiable instrument. It is issued by a pany, accepted by thereceiver of a good, and guaranteed by an investment bank. Bills of exchange may bereferred to as two-name instruments. The supplier may sell the bill to a discount housefor cash rather than waiting for the acceptor to pay the bill at the end of the stated timepeCommercial paper is a type of bearer document for short-term borrowing. It is suitablefor large panies who wish to raise a lot of short-term cash. Commercial paper is asingle-name instrument, ie it is not guaranteed by a bank, so the issuing panies haveto meet certain minimum requirementsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipPage 31Chapter 2 SolutionsSolution 2.1A sole trader has unlimited liability. The whole of the owners personal wealth is at riskif the business runs into debt and is suedIn a partnership there is unlimited liability. Partners are jointly and severally liable forthe debts of the business. Their entire personal wealth may be at stake if the partnershipis sued successfullyA limited pany is owned by shareholders. Shareholders'liability is limited tofully-paid value of the shares they own. Creditors cannot claim payment fromshareholders' personal wealthIn a limited liability partnership, each member's liability is limited to the amount that heor she put into the businessThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 32CT2-02: Company ownershipSolution 2.2PartnershipLLPLimited panySource of finance PartnersMembersShareholdersLegal identityNot separateSeparateSeparateLiabilityUnlimitedLimitedLimitedDocumentationNPartnershipMemorandum andremended: must Association; mustregistered atCompanies House Companies Houseand granted aand granted aIncorporation.IncorporationDClosureNone, though the Rules on disclosure; Rules on disclosureaccounts will be must produceall panies mustneeded by theaudited accounts if produce auditedInland Revenue to turnover exceeds f1 accountscalculate eachmillion. inlandpartners taxRevenue needsliabilityaccounts tocalculate taxliabilityTaxPartners pay ine Members payCompanies paytaxine taxcorporation tax.Solution 2.3People may be reluctant to bee involved as a part owner of a partnership since theyrisk their entire personal wealth. With limited liability people should be much morwilling to provide capitalPLCs have to ply with certain rules regarding the standards of accounts, which maygive investors more confidence in the pany.Where shares are quoted on an exchange, their value is easily determined. If the panyhas to raise finance by selling shares, the price can be quickly negotiated. A partnershipmay have difficulties determining the "value"of a part ownershipC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipSolution 2, 4The main factors to consider when deciding on the type of business organisation to set upwith your friend arethe need for finance and the amount of finance you are able to contribute the more youneed and the less you have, the more likely it is that you will consider setting up apany.the ease of raising finance in the future the greater your plans to expand, the greater thetendency to set up a pany.liability for debts- the greater the possibility of running into debt, the more likely you areto consider setting up a panyease of setting up the quicker and cheaper you want the set up to be, the more likely youare to set up a partnershipdisclosure the more reluctant you are to disclose information about the business themore likely you are to set up a partnershipcontrol of the business the greater the amount of control you want to retain, the morelikely you are to set up a partnership. However, you could set up a private limitedpany with just a few(even two)shareholders if you wish to retain tight controlroles and responsibilities- the firmer you wish the roles and responsibilities to bedefined, the more likely you are to set up a pany. However, you could have a firmpartnership agreement. This is linked to the trust you have in your friendthe type of business- the greater the need to display mitment in order to gain trust, egaccountants, solicitors, the greater the tendency to set up as a partnershipNB. The LLP might be a good promise!The Actuarial Education CompanC IFE: 2009 ExaminationsCT2-02: Company ownershipSolution 2.5Ownership of asset- Under a hire purchase agreement, ownership of the asset doesnot pass to the buyer until the last payment is made. Under a credit sale agreement theownership passes immediatelyStructure of payments- Both involve a series of (usually fixed) payments over a periodof typically up to ten yearsEvent of default- Under a hire purchase agreement the owner can reclaim the assetUnder a credit sale, the recipient of the payments must sue to reclaim the outstandinamountsSolution 2.6A multinational loan to a country experiencing short-term economic problemsFor example during the late nineties, the Mexican currency was under pressure,hich caused severe shocks within the economy. In order to support thegovernment, the other central banks organised a syndicated loan of many billionsof dollars until the crisis was resolvedBanks lending to the panies that built the millennium dome would haveloaned on a syndicated basisChannel Tunnel projectSolution 2.7a bank overdraft will be more expensive. The reasons areOverdrafts are more flexible for the borrower. This means that they are lesspredictable for the lender.Loans are normally secured on assets of the pany. Overdraftsunsecured and therefore more risky for the lender. ( More risk means higherreturn expected.)Loans are longer term, which may mean that interest rates are slightly lower thaninterest rates for overnight borrowing(which is effectively what overdrafts are)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipSolution 2. 8(i) Hire purchase and credit sale agreementsHire purchaseAdvantage to supplier: the supplier retains ownership of the goods until the endof the term of the agreement and can reclaim them if the buyer does not keep upthe repayments Seller receives interest on top of the price of the goodsDisadvantage to supplier: few disadvantages(although not as good as getting theup-front)Credit sale agreementadvantage to supplier: seller receives interest in addition to the pricedisadvantage to suppliers: legal ownership of the goods passes to the buyer at thestart of the agreement. If the buyer defaults on the repayments, the seller has tosue the buyer through the courts(ii) Operating and finance leasesOnThe owner of the asset retains most of the risks associated with ownership of the assetThe term of the lease will be substantially shorter than the expected useful life of the assetFinance leaseThe lessee takes on most of the risks and rewards of ownership The term of the lease willbe close to the expected useful life of the assetThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-02: Company ownership(ii Bank loan and loan facilityBank loanHere, a fixed sum is lent to the borrower on a fixed date for a specified termLoan facilityA sum is made available to the borrower. The borrower may draw the sum in instalmentsgiving the bank a few days notice of each instalment. In addition, there may be flexiblerepayment arrangements. Interest is only charged on the amount outstanding(iv) Loan facility and overdraftLoan facilitA sum of money is available for borrowing. This sum can be drawn in instalments andadded to the borrower's bank account. The bank will need a few days' notice before eachinstalment is made. There may be flexible repayment termsOverdraftThe borrower is granted a facility to draw money out of a current account so that itsbalance bees negative, subject to an agreed maximum limit. The borrower does nothave to give any notice to be able to use the overdraft. There are no set repayment termsHowever, the bank has the option to demand immediate repayment of the overdraft at anytime with no notice(v) Credit sale and trade creditCredit saleThis will be repaid by regular instalments over a period of time. The instalments willinclude an element of interestTrade creditThis means that a pany can pay its supplier for goods and services after they have beenreceived. Typically, business customers will settle their bills 30 to 60 days after they havebeen invoicedbills are then settled in full, in one payment. No explicit interest ischarged although suppliers may give discounts for"cash on deliveryC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-02: Company ownershipPage 37(vi) Invoice discounting and non-recourse factorinInvoice discounting (recourse factoring)advantage to supplier: supplier receives a certain proportion (say 85%)of theamount it bills immediately from the factordisadvantage to supplier: the supplier still has to provide its own crediadministration and collect its debts. It bears the credit risk. In addition it has tot to the factor based on the amount of time between the date theadvance was made and the date that payment was received from the customerNon-recourse factoringadvantage to supplier: supplier receives a certain proportion(say 85%)of theamount it bills immediately from the factor. In addition the factor gives a fulladministration service and will take on the credit risk associated with thenvoicesdisadvantage to supplier: the main disadvantage is that the factor wants only toget paid as soon as possible. It has no particular interest in maintaining goodrelationships with the supplier's customers. It may therefore apply pressure tosuch an extent that the supplier loses goodwill and subsequently custom(although this may not be such a disadvantage if the customers were badayersThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-02: Company ownership(vii Bills ofexchange and sterling paperBills of exchangeA pany can issue a bill to one of its customers. If the customer accepts the bill, and itis guaranteed by an investment bank, the original pany can sell the bill to a discounthouse for cash, rather than having to wait for the acceptor to pay upBills of exchangetherefore provide short-term cash to paniesCommercial paperA pany can issue mercial paper directly to investors. The pany must meetcertain requirements, such as being listed on the London Stock Exchange. The term of themercial paper must be between one week and one year. The minimum size in whichsterling mercial paper can be denominated is E500,000Both of these forms of borrowing are short-term negotiable financial instruments Themain difference between them is that bills of exchange must be guaranteed by aninvestment bank, and are therefore two-name instruments, whereas mercial paper isnot guaranteed by a bank, and is therefore a single-name instrument. Bills of exchangecan be issued by any pany, whereas mercial paper can only be issued by largequoted panies that meet certain requirementsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-03: TaxationPage 1Chapter 3Taxation>e Syllabus objectives(iv) Describe the basic principles of personal and corporate taxationDescribe the basic principles of personal taxation2. Describe the basic principles of the taxation of capital gains3. Describe the basic principles of pany taxation4. Explain the different systems of pany taxation from the points of view of anindividual shareholder and the panOutline the basic principles of double taxation relief.0 IntroductionChapter 3 looks at the various ways in which individuals and corporate bodies are taxedThe sections in this chapter are as followspersonal taxationpany taxationcapital gains taxother taxesdouble taxation reliefThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 2CT2-03: TaxationThe discussion of taxation in this chapter will help your understanding of a number ofother areas that you will study later, for example:the characteristics of investments and investors( Chapters 4, 5)the structure of accounts and how to analyse them( chapters 8, 12 and 13)the analysis of the structure of pany capital( Chapters 15 and 16)a In the past, the examination has tested knowledge of personal and corporate taxation,e and the ability to analyse the tax implications of particular choices made by investorsand paniesAt this stage, concentrate mainly on understanding the basic principles. The taximplications of investors'choices are covered in Chapter 4, and the tax implications ofpanies choices are discussed in Chapters 4, 8, 12, 13 and 16C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-03: TaxationPage 31 Persona taxationPersonal taxation will typically be levied on all the financial resources ofindividualsThe principal sources are thereforeine(whether earned- wages and salaries-or unearned - investmentine and rent)profit from operating as a sole trader or partnerinherited wealthinvestment gainsvalue of assets heldIne tax is often one of the main sources of tax revenue for governments. Employedand self-employed(sole traders and partners) pay ine taxIn addition, most countries also levy social security contributions on earningsIn the UK, national insurance contributions count towards certain social securitybenefits such as incapacity benefit and retirement pensionsGovernments may also introducea tax on capital gains, ie a tax on the gain made from selling an asset for morethan it cost. We shall look at capital gains taxation in Section 3a wealth tax, ie a tax on the amount of wealth, such as property, owned. In thethe Council Tax is a tax based on the value of property. It is used to raisemoney for local governmentan inheritance tax, ie a tax on the amount transferred on death there is usually agenerous allowance so that most of the population are not caught by this taxWealthy individuals often place their assets in trust in order to avoid such taxesThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 4CT2-03: Taxation1.1 ConsiderationsThe state has to decide what to tax and how much to tax. it also has to consider thepractical issues of collecting the taxTaxing cashflowsIn many countries taxation is limited to cashflows, since these are indicative ofcash being available to finance the tax payable. Where tax is determined on thevalue of assets, there is the possibility that these assets may have to be realisedin order to generate the funds needed to pay the taxes. In other words it is easierto tax ine than wealth because ine is an accessible cashflow Wealth is oftentied up in large indivisible units such as a large property and it is sometimes necessaryto sell a large inheritance in order to pay the inheritance tax on itTaxing in arrearsIn addition to ability to pay, governments will also seek to ensure that citizenshave sufficient retained ine and wealth to meet their essential needs. It ismon,therefore, to assess tax liabilities in arrears taking into account allrelevant sources of wealth and/or ine and to exempt some basic levels ofine or wealth from the calculationsHowever, there may be some arrangement whereby tax is levied at source onine throughout the tax period, in order to accelerate tax flows to thegovernment. In the UK, for example, most employed people pay tax weekly ormonthly through the paye (pay as you earn) scheme. In this case, the finalassessment for the period will establish the final payment (or credit)needed togenerate the correct overall tax payments. Individuals might receive a tax rebate atthe end of the year if they have paid too much in tax or be asked to pay more tax if theyhave paid too little. The self-employed in the UK pay ine tax twice a year,inJanuary and July. An estimate is made of the current years earnings and when theactual earnings are known, an amendment is madeTaxing onceIn general, governments will seek to ensure that revenue flows are taxed onlyonce in the hands of the recipients However, if taxes are also levied on wealthor the value of specific assets, then double"taxation will be likely (since theassets may well have been acquired from after-tax funds).C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-03: TaxationPage 51.2 Calculating taxable ineThe government may make adjustments to total ine to arrive at taxable ine, iethat part of ine subject to tax. The government might exempt some sorts of ineand expenditure from tax, so there might be some tax-free ine and tax-freeexpenditure. On the other hand they might treat some sorts of benefits as ine in kindand therefore as taxable ine. If any ine has been received from investments andsavings this must be added on to total ine even if tax has been deducted at sourcein order to assess the correct amount of tax to payFinally, there is usually an allowance, ie an amount that a person is allowed to earnbefore paying any tax. This is deducted from total adjusted ine to arrive at taxableIneTax-free ineCertain items of ine are tax free. For example, in the uK the following aretax-free:most profits from gamblingmost forms of social security benefitine from certain types of investment such as an Individual SavingsAccount(ISA)In the uK most forms of means-tested benefits, such as ine support, are tax-free andmost benefits that are not means-tested, such as pensions, are taxable. Means-testedbenefits are those which require a persons ine(or means)to be assessedTax-free expenditureTax relief may also be available on certain forms of expenditure such ascontributions to an approved pension scheme and charitable gifts In general, taxrelief works to reduce a persons taxable ineThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 6CT2-03: TaxationIne in kindWhere an employee receives additional "fringe"benefits as well as a wage orsalary, the value of the benefits is usually included in the definition of taxableFor examppany cars available for private usemedical insurance premiumsfree housingsubsidised mortgages (ie a reduced rate of interest payable on mortgage finance)Investment ine deducted at sourceInvestment ine often has ine tax deducted at source. For tax purposes,the grossed up equivalent is included as taxable ine, and the tax deductedat source can be offset against the person's tax liability.For example, interest from a building society account is often received net of tax, thebuilding society having already paid tax to the tax authorities. When assessing aperson's tax liability, the tax authorities will need to add the gross amount of interestpaid by the building society against the person s t lauda es but will then offset the taxreceived to the total ine received from all other sourcSimilarly, in the UK, ine in the form of pany dividends are paid net of tax(forexample, net of 10% in the UK), with an attaching tax credit for the recipient. This istermed franked investment ine. The tax credit cannot be reclaimed by the investorand those who are subject to a higher rate of tax on dividend ine have to payadditional taxA∥ lowancesThe underlying"tax-free "level of ine or capital may also need to be adjustedto reflect personal or family circumstances. Thus, a tax-free slice of ineknown as a personal allowance may be deducted from ine beforedetermining liability to tax. other additional allowances also exist, for exampleage allowances. In some countries there may be an additional allowance formarried couplesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-03: TaxationPage71.3 Tax ratesConsideration must be given to whether marginal tax rates should increase,remain constant or decrease as the individuals taxable base varies Themarginal tax rate is the proportion of an additional unit of ine that is taken in taxFrom April 2008, the marginal tax rates are 20%(the basic rate)and 40%(the higherrate). These rates are applied to bands of taxable ine. As ine increases and istaken into a higher band, the higher marginal rate applies to the additional ineearnedQuestion 3. 1How is taxable ine calculated?Question 3. 2Assume that the personal allowance is f5, 000, and that the marginal tax rates are 20%for the first 540.000. and 40% for taxable ine above this. assuming there are noadjustments to total ine, how much tax will a single person earning f50, 000 payWhat proportion of total ine is paid in tax?The Actuarial Education CompanC IFE: 2009 ExaminationsPage 8CT2-03: Taxation2 Company taxationCompanies are liable to corporate ine tax(corporation tax) on their taxableofits2.1 Calculating taxable profitTaxable profits usually include both ine(less expenses) and capital gainsWe will look at the assessment of capital gains in Section 3Accounting profitThe starting point for a pany' s tax assessment is "profit on ordinaryactivities before taxation". We will look at the ine statement in Chapter 8. Thefigure in the accounts is called the accounting profit. Very briefly, this is calculated asSales revenuless Expensesng piplus Non-trading ine(interest, dividends, capital gains)Profit before tax and interestless Interest paidProfit beAfter tax has been deducted, the pany then distributes some of the after-tax profitsto the shareholders in the form of a dividend and retains the rest in the business asretained profitTaxable profitThis figure(accounting profit before tax) then needs to be adjusted since thefor puting taxable profits are not always the same as the rules that will haveused for puting accounting profitThe main adjustments are:Add back any business expenses or potential expenditure shown inaccounts which are not allowable for tax(eg entertainment of customersfinesfor illegal acts)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-03: TaxationPage 9Add back any charge for depreciation, and instead subtract the allowablecapital allowance" Depreciation is an allowance for the using up of capitalequipment during the years production. It is treated as a cost in the inestatement. Companies can choose a number of ways of calculating thisdepreciation allowance but the tax authorities have to treat all paniesconsistently and so they use their own capital allowances. Depreciation isdiscussed in more detail in Chapters 8 and 9deduct any special reliefs, eg research and development costs may be ableto be deducted immediately.In addition, the pany might not have to pay tax on dividends earned from itsshareholdings in other panies. (See Section 2.3 below.)2.2 The rates of taxIn the UK from April 2008, the standard rate of corporation tax is 28%. Smallpanies pay a lower ratefor nine years prior to April 2008, the standard rate of corporation tax in the UK was30%. Corporation tax rates around the world vary considerably. For simplicity, the30% rate may often be used as a proxy for the true rate of a pany's corporation taxHence, both the Core Reading and ActEd notes often use a corporation tax rate of 30%02.3 Uses of the corporation tax systemSome countries give relief to shareholders to ensure that dividends are notsubject to both personal and corporate ine tax.Since dividends are paid by a pany out of its post-tax ine, tax has already beenpaid on the dividends and so dividend ine is known as franked ine, ie inethat has been taxed. Most governments give at least some credit to the shareholder forthe tax that has already been paid. In this way the shareholders are imputed or ascribedat least part of the tax, ie they are deemed to have paid at least part of the taxSuch an "imputed"tax system ensures that there is no disadvantageexperienced by the shareholder when a pany distributes profits. withoutsuch a system, the pany would pay corporation tax on its profits and the shareholderwould, in addition, pay ine tax on the dividends. This would discourage firms fromdistributing profit as dividendsThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-03: TaxationHowever, governments sometimes seek to incentivise panies to retain andreinvest earnings. The government may wish to pursue a faster rate of economicgrowth and therefore may try to encourage greater investment by firms. Since a largeof funds foit, the governmentcould use the tax system to encourage firms to plough their profit back into the businessThis may be achieved by levying higher taxes on dividends than on"retainedprofits, or by allowing tax relief for new investment (such as the "capitalallowances"mentioned above). Profits flowing from such investment wouldthen be taxed in the usual way. a system that has been used in the past in the uk isone that allows"accelerated depreciation"of new capital equipment. When a panybuys new capital equipment, eg a new machine, it estimates how long the equipmentwill last and"writes off part of its value as depreciation(and therefore as a cost) eachear. The cost of the machine is therefore spread over the life of the machineAccelerated depreciation allows the pany to depreciate a large part of the machinein the early years, thus increasing the pany's costs, decreasing its profit andtherefore decreasing its tax liability in the early years. Profitability and therefore taxliability will increase in the later yearsa particular example of this relates to pension provision, where the governmentmay seek to encourage private and institutional pension arrangements byoffering tax reliefs ( or even subsidies) on contributions and, possibly,investment earnings within the pension scheme. While the final pension benefiwill be subject to tax, when paid, the individual recipient will often benefit from alower personal tax regime when in retirement. In some countries, such tax-advantaged funds are available for other purposes (such as house purchase,medical expenses or education and training finance)Question 3. 3What are the three main adjustments that have to be made to accounting profit to arriveat taxable profit?Question 3. 4How can the government use the corporation tax system to encourage or discourage aparticular activity'C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-03: Taxation3 Capital gains taxIndividuals and panies are typically subject to capital gains tax onchargeable gainsChargeable gains normally fall into the tax year of assessment during which thegain is realised so that, again the funds to pay the tax should be available3.1 Calculating chargeable gainsCapital gains on most assets are chargeable. However, there may beexceptions.ExceptionsFor example in the uK the following assets are free from capital gains taxprivate motor carsa main private residenceforeign currency obtained for personal useBritish Government securities and other qualifying fixed-interest stockssmall tangible moveable assets(or chattels) worth less than E6, 000(eg furniture,jewellery, paintings, antiques etc)Transactions between a husband and wife do not normally attract capital gains taxBasic definitiona chargeable gain is typically defined assale price- purchase costThe sale price can be reduced to reflect any costs associated with the sale. Thepurchase cost can be increased by any costs associated with the purchase, andany expenditure made to enhance the value of the asset during the period theasset was held. In normal circumstances, the purchase cost would be theoriginal cost of the assetThere may be further deductions, depending on whether the tax is being applied topanies or individualsThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 12CT2-03: TaxationIndexation allowanceSome countries have allowances to remove the inflationary element of any gainor to encourage individuals to retain assetsWithout such an allowance, the formula above would mean that increases in nominalasset values due to inflation would be taxableIt is mon for panies to offset inflation by deducting a further indexationallowanceIn the UK, this is calculated with reference to the Retail Price Index(RPD, whichreflects the rise in the general level of prices of goods in the UK. Indexation allowancetables are published monthly by hmrcSince 2008 in the UK, for individuals(including sole traders and partners),noallowances are made for inflationCapital lossesThe above chargeable gain calculations may result in a negative number. Such anamount is known as a"capital lossCapital losses can normally be offset against capital gains in the same yearCapital losses cannot, however, be offset against any other form of taxationAny "unused"capital loss may be carried forward to be offset against capital gains inany future year(s)The rules for offsetting capital losses do not apply if the loss is only caused by theindexation allowanceC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-03: TaxationA∥ owancesIn most countries, individuals are given an allowance each year and only paycapital gains tax on chargeable gains in excess of this amount. For the tax year2008-2009, the annual exempt amount (AEA) in the uK is 59, 600. Companies do notusually receive an allowance3.2 The rates of taxFor individuals, the amount chargeable to capital gains tax could be added on tothe ine liable to ine tax and charged to CGT at the individual's marginaltax rate. In the UK, from 6 April 2008, a flat rate of 18%will apply to all capitagains.In the uk, the taxable gain used to be treated as additional ine. The gain wastaxable at two different rates if part of the gain fell into the basic tax band and part intothe higher tax band. hogains in excess of the annual exempt amount are taxed at 18%, regardless of anindividuals marginal rate of taxampAssume that the capital gains allowance is f9, 600After ine tax. Mr x has i1.000 of the basic tax band left unused. He makes achargeable gain of f5, 000. How much capital gains tax does he pay?Nothing, because he would only pay CGT on chargeable gains in excess of f9, 600Question 3. 5Assume the same tax system as given in the above example. Mrs Ys marginal tax rateis 40%. She makes a chargeable gain of f15, 000. How much capital gains tax does shepayCompanies pay corporation tax on chargeable gains at the rate at which theynormally pay corporation taxThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 14CT2-03: TaxationQuestion 3. 6Which of the following items would be subject to capital gains tax? Justify yourThe sale of mr X's house2. The sale of a house that Mr X bought for his long-lost aunt to live in3. The sale of Mr Xs car(a vintage Rolls Royce)The sale of Mr X's collection of antique silver snuff boxes(valued at f18, 000)The transfer of mr Xs holiday cottage to his wifeQuestion 3.7Are the following true or false?(1) Chargeable gains made by individuals are taxed at their marginal rate(i) Capital losses can be offset against profit made from normal trading activities(iii) A husband and wife have an effective capital gains allowance of f19, 200C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-03: Taxation4 Other taxesother categories of tax levied on panies and individuals includeStamp duty on contract documents. For example, when an individual buys ahouse, he/she must pay stamp duty tax based on the value of the houseInheritance taxesProperty taxesInheritance taxes and property taxes were discussed briefly in Section 1There may also be a system for levying tax on expenditure, either in respect ofgeneral expenditure (eg a sales tax)or on specific types of expenditure (egcustoms duties and excise taxes)a sales tax(as is used in the US) is collected only at the point of final sale to theconsumer. Value Added Tax (as is used in the European Union) is collected at eachstage of the production process according to the value added at each stage of theproduction process. These taxes are levied on most goods though there are usuallyexceptions. Certain classes of"essential"expenditure, such as basic foodstuffsmay be exempted from sales taxes. In the UK, the standard rate of vat is 17. 5%but domestic fuel and power is taxed at 5% and some items such as food and books arezero-ratedCustoms duties are taxes on imported goods. Imported goods are taxed in differentways in different countries. Such taxes often involve flat taxes based on the value of thegoods imported, weight taxes, taxes based on the physical size of the goods and specialtaxes for certain industries such as the car industry based on emissionsExcise duties are duties or taxes levied on goods produced and sold within the countryeg duties on petrol,cigarettes.Such specific taxes may be designed, additionally, to encourage certain patternsof consumer expenditure or to raise revenues for particular categories ofgovernment expenditure. For example, by taxing cigarettes the government coulddiscourage smoking and hence improve health; by taxing petrol(and perhapsadditionally subsidising public transport), the government could discourage the use ofthe private motor car and hence reduce congestion and pollution. The government coulduse all tax revenue from cigarettes for use in the health serviceThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-03: Taxation5 Double taxation reliefMost countries have a double taxation agreement with other countries the uKThesepreventne being taxed in theof origin as well as in the UKelief (DTR)means that the local tax authority will alloypanies and individuals with overseas ine to offset tax paid overseasagainst their liability to domestic corporation ( or ine) tax on that ineThe maximum offset is the rate of tax that would have been paid locally on thegrossed-up ine. Double tax relief cannot result in tax being reclaimed from thetax authoritiesDTR is only available on ine received from abroad, not on revenue of acapital natureExampleAssume a 28% rate of corporation tax in the UK1) XYZ(a UK pany) earns f10, 000 in the United States where it is subject to40%tax. In the UK, the remaining t6, 000 of after tax earnings will not besubject to further tax. However if the pany has other earnings in the uk,taxwill be paid in the usual manner to the UK authorities2) XYZ earns f10,000 in France where it is subject to 25% tax. In the uk thee10,000(or f7, 500 after French tax) will be subject to an additional 3% tax. So,XYZ will end up with f7, 200 after UK taxQuestion 3. 8Explain what is meant by"double taxation reliefa Examination questions in the past have tended to be knowledge based. For exampleExplain how a pany's UK corporation tax liability is calculated. (September 2003adapted)You would need to discuss taxable profit and double taxation relief.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-03: TaxationPage 17Chapter 3 SummaryPersonal taxationPersonal taxation is levied on all the financial resources of an individual. The mainsources areine both earned(wages and salaries)and unearned (investment ine andprofit from operating as a sole-trader or partnercapital gainsinheritancewealth eg propertyIndividuals (including partnerships) are usually subject to ine tax and may, inaddition, pay social security contributionsIne tax is calculated with reference to taxable ineTaxable ine includes ine received in kind, such as subsidised mortgages, andalso gross investment ineIne tax liability may be reduced by tax relief on certain forms of ine, suchine from an ISA, and on certain forms of expenditure, such as contributions to anapproved pension scheme.a person' s taxable ine for a certain year will be reduced by any allowances to whichthey are entitled, eg personal allowance, age allowanceCorporation taxCompanies are liable to corporation tax on their taxable profits. taxable profits includeboth ine(less expenses )and capital gains. A pany' s accounting profit has to beadjusted to taxable profit bydding back on any business expenses or potential expenditure that are notallowabledding back depreciation and deducting the capital allowancededucting any special reliefs, eg research and developmentThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-03: TaxationThe government can use the corporation tax system to encourage or discourage certainbehaviour. For example, the government can encourage investment by taxing retainedprofit less heavily than distributed profit or it might encourage pension schemes bygranting tax relief on pension contributionsCapital gains taxIndividuals and panies are subject to capital gains tax on chargeable gainsa chargeable gain is defined as: sale price- purchase costCapital losses can normally be offset against capital gains in the same yearIndividuals are usually given an annual exempt amountor an Iidual in the uKany taxable gain is taxed at a flat rate of 18%. Companies pay corporation tax onchargeable gains at the usual rateDouble taxation reliefMost countries have a double taxation agreement with other countries Theseagreements allow panies and individuals with overseas ine to offset tax paidoverseas against their liability to UK corporation (or ine)taxC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-03: TaxationChapter 3 SolutionsSolution 3. 1Taxable ine is calculated as followsne earnedInplus gross investment ineless tax-free expenditureless allowanceSolution 3.2There is a personal allowance of f5,000, so the person is only taxed on f45, 000 ofIneax ratesTax bandsax alTaxed 20%40.0008,000Taxed a 40%5.0002.000To£10,000Total tax paid is 20% of total ine. This is known as the average rate of taxSolution 3. 3The three main adjustments areadding back on any business expenses or potential expenditure that are notallowableadding back depreciation and deducting the capital allowancededucting any special reliefs, eg research and developmentThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-03: TaxationSolution 3. 4The government canuse a lower rate of tax on retained profit than on distributed profit to encourageInvestmentallow pension contributions to be treated as an expense and grant tax relief toinvestment earnings within the scheme to encourage the setting up of pensionschemesSolution 3. 5Mrs Ys chargeable gain is in excess of the annual allowance of f9, 600. She willtherefore pay capital gains tax on E15,000-E9, 600=55, 400Capital gains tax on£5,400at18%is£972Solution 3. 6The following items will be liable for CGTbecause the house was not mr X's main residenceno exemption for snuff boxes !(because the collection is valued at more than£6,000)The following items will not be liable for CGTassuming it is Mr Xs principal residencebecause Cgt does not apply to private motor cars5. because it is a transaction between a husband and wifeC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-03: TaxationPage 21Solution 3.7( i) False. They are taxed at 18%(ii) False. Capital losses can only be offset against capital gains: they cannot beoffset against any other taxSolution 3. 8Allows overseas tax paid in countries for which double taxation agreements existto be offset against liability to domestic taxApplies to individuals who receive dividends from abroad, and paniesreceiving dividends or profits from overseas branchesThe credit is equal to the lower of foreign tax paid and the uk tax dueDoes not apply to capital taxesThe Actuarial Education CompanC IFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 1Chapter 4Financial instrumentsSyllabus objectives(iii) Describe the structure of a joint stock pany and the different methods bywhich it may be financed.Describe the different types of loan and share capital3. Distinguish between authorised and issued share capital(v) Demonstrate a knowledge and understanding of the characteristics of theprincipal forms of financial instrument issued or used by panies and theways in which they may be issued.Describe the characteristics, from an issuer's point of view ofunsecured loan stocksEurobondpreference sharesordinary sharesconvertible unsecured loan stocksconvertible preference shareswarrantsfloating-rate notessubordinated debtoptions issued by paniesThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 2CT2-04: Financial instruments0 ntroductionThis chapter looks at the principal sources of long-term capital available to paniesdebt and equity. We will consider the risk and return aspects of each type of finance fromthe viewpoint of the pany raising the money (rather than the investor). However, weshall see that the attitudes of investors to different types of finance are critical indetermining whether or not a particular method of finance could or should be usedIn Chapter 2 we looked at the legal basis of a pany and some of the medium- andshort-term forms of capital available to panies. In this chapter we concentrate on thelong-term forms of capital which constitute by far the largest portion of pany financeIn Chapter 3 we looked at the principles of personal and corporate taxation. Thisknowledge will be useful in this chapter when analysing the tax implications of particularmethods of finance for both investors and for panies. In Chapter 6 we will continueour study of finance by looking at the process of raising finance and issuing sharesIn the past, the examination has tested knowledge of the main forms of long-termfinance and the ability to analyse for both investors and for panies the relativemerits of particular types of long-term financeC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 31 Loan capita/(Debt)1.1 IntroductionA pany issues loan capital to raise money from investors. In return, thepany will pay the investor a stream of interest payments plus an eventualreturn of capital. The amounts of interest and capital payments to be made willbe specified at outset (or at least a formula to calculate the payments will be set out)This contrasts with shares, where dividends are paid at the discretion of the panysdirectorsUK listed panies often raise more finance each year by borrowing from investors byinstruments are often referred to as"bonds", and short-term instruments as"bills, capitalissuing loan capital than they raise by issuing shares. Long-term loanIssues of loan capital may be listed on a stock exchange. This applies to bothtraditional and Eurobond issues(see later)Holders of loan capital are creditors of the pany. They will not have votirights. They will receive specified"interest" payments which are a cost to the panynot a distribution of profits. On a winding-up they will rank equally with, or in some casesabove. other creditorsFeatures of loan capitalIt is conventional to refer to loan capital in units of f100 nominal. Thenominal amount of a loan is often referred to as its " "par value"It is usual to express the interest payments as a proportion of the par value.For example, a holder of t100 nominal of a 10% debenture will receive t10months so this debenture would pay f5 every six months per f100 nominal held 4interest per annum. The loan coupon payments are normally made every sixIt is normal to issue loan capital at a price close to, or just below, parUnlike shares, there is no legal restriction on the issue price relative to par. SE98, E99, f100, f10l etc are all possible issue prices per E100 nominalAlmost all loan capital is redeemed at par.As with shares, the market price of &100 nominal of loan capital need not be f100Most loan capital is redeemable on a set date, often after 10 to 20 yearsThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 4CT2-04: Financial instrumentsQuestion 4. 1What is the total amount of cash you would receive if you purchased f200 nominal of a6% government bond redeeming on 31 December 2017, and purchased on 1 January2007?Since bonds are tradable, the price of a bond varies with supply and demand for thebonds. One of the main influences on the price of a bond is the interest rate in theeconomy. There is a see-saw relationship between interest rates and the price of a bondQuestion 4.2Suppose interest rates rise in the economy, what would happen to the demand for afixed-coupon bond and hence what would happen to the price of the bond?VariationsMost loan capital is redeemed at par on a set date and coupons are paid every sixmonths. You may also e across the following variationsthe capital repayment may be made at a time between two dates at the panysoptioninterest payments may be set as a fixed margin (eg %4%)over a benchmarkinterest rate, eg six month LiBOR rather than as a fixed absolute amount. Theseare known as "variable rate issuesinterest and redemption proceeds may be linked to an inflation index. These areknown as“ index- linked” bondsinterest payments may increase in steps in a similar way to stepped preferenceshares(see later)eg 6% for three years, 8% for the next three years and so onThese are known as"stepped"bondsthe pany may be able to repay the loan at any time(known as a"call optionon the bond)the loan stock holder may be able to demand repayment at any time (known as aput option"on the bond)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 5capital repayments might be made throughout the term of the loan(like a capitaland repayment mortgage). Such arrangements are known as"sinking fundThey are now rare.The rights of bondholdersThe rights of holders of loan capital will be set out in a loan agreement drawn upwhen the loan is issued. In most cases, a trustee is appointed to act on behalfof the loan stockholders. The trustee is normally a corporate body such as abank or insurance pany.The legal documentation setting out theobligations of the issuing pany to the loan stockholders is known as theTrust DeedQuestion 4.3What details might you expect to find in the trust deed of a bond issued by a panyThe main characteristics of debt or loan capital were discussed above. We nowconsider some categories of loan stock.1.2 Debenture stocksDescriptionDebentures are loans which are secured on some or al of the assets of thepanyThis means that, if the pany fails to make one of the coupon payments or thecapital repayment, various actions are available to the stockholders they may:appoint a receiver to intercept ine from the secured asset(s)(eg renton prtake possession of the secured asset to sell it in order to meet their debt(with any surplus being returned to the pany ). This action is calledforeclosureThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 6CT2-04: Financial instrumentsThere are two types of debentureMortgage debenture(fixed chargeA fixed charge means that there are specific secured assets mentioned in the legaldocumentation for the mortgage debentureThe pany will be able to sell or make major alterations to the secured asset only withthe mortgage debenture holders permission(i) Floating charge debentureThe pany can change the secured assets in the normal course of businessFor example, it can sell the assets, so long as they are replaced by equallysatisfactory assets from the debenture holders'viewpoint. It will be the trustee'sresponsibility to give permission for thisWhen a pany fails to make an interest or capital payment, the debentureholders can apply to the courts to make the floating charge bee a fixedcharge. This is called"crystallisingDebentures and loan stocks are used to raise large amounts of funds(typicalissues in the UK may range from E30m to E100m). They have a fixed redemptiondate and carry a fixed rate of interest, so that the borrower has a known debtservicing mitmentThe interest payments are tax deductible - meaning that the debenture interest isdeducted from pre-tax profits before the calculation of tax liability (as an expense ofthe pany-but the debenture holders are creditors of the pany andhave no right to interfere in its runningHowever, the interest payments must be made irrespective of the pany'sprofitability or cashflow position and, if the debentures are secured against theassets of the pany, failure to adhere to the agreed terms may place thecontinuation of the pany at risk.We will now consider the main investment characteristics of debentures: the risk. returnand marketability of debenturesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 7RiskPayments on debentures, unlike dividend payments to shareholders, are a legal obligationon the pany and (if there are sufficient assets) loan capital holders get repaid fully inthe event of a winding-up before shareholders can receive anything. Therefore, debenturesin a given pany are much more secure than ordinary or preference shares in the samepanyAs we have seen, there are two ways in which the security on a debenture can be providedOften, a fixed charge will be backed up by a floating charge as well, in case the chargedasset under the fixed charge turns out to have insufficient value to meet the money due tothe debenture holders. The rights of debenture holders are overseen by a trustee.There is still an element of risk attaching to debentures This is because of the risk ofdefault bined with the risk that the asset over which the fixed charge has beenplaced will turn out to be insufficient to cover the loanReturnDebentures carry the risk that coupon payments or capital repayment may notbe made, but the stockholders have security in respect of the secured assetsAs such, debentures do trade at yields above government securities, although some ofthis might be accounted for by the lack of marketability(see later)The value of all payments -capital and interest -may be eroded by inflationDebenture stocks may also not be readily marketable. The total return ondebentures will reflect all these risks. generally, the total return(referred to as thegross redemption yield, or GRY of a debenture would be expected to besuperior to that of a convertible preference share(discussed below) because theconvertible share offers not only an ine yield but a potential capital gain aswell, thus the required ine yield is lower than a debentureless than that of an unsecured loan stock(discussed below) because an unsecuredloan stock offers no capital growth and is far riskier than a debentureThe gross redemption yields on debentures reflect lower marketability as much as riskThe required margin( the required margin is the additional yield required on the loan stockin order to make it attractive to investors relative to government stock) for debenturesissued by panies which are considered to be very secure is typically 12% higher thanon government bonds of similar term and coupon. This yield margin increases for lesssound panies as the perceived riskiness of the debenture stock increasesThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 8CT2-04: Financial instrumentsMarketabilityMarketability of debentures is usually worse than for government bonds: there are biggeroreads between buying and selling prices, and lower volumes traded. This is because thetypical issue size is smaller (eg f30m). Therefore trading in a particular debenture can beinfrequent. With some issues marketability can be very low indeed. In generalmarketability is highest just after a new issueConclusionThe existence of a fixed and/or floating charge together with the appointment of a trusteeis designed to reduce the risk to the debenture holder. However, the security ultimatelydpayments, and failing that, on the market value of the charged assets. In practice neithercan be guaranteed for the full outstanding term of the debenture. Therefore, debenturestocks are considered more risky than government bonds1.3 Unsecured loan stocksDescriptionWith unsecured loan stock there is no specific security for the loanIf the pany defaults, the loan stockholders'only remedy is to sue thepany. In practice this means asking the courts to wind up the pany. When thishappens, any debenture holders will have a prior claim to the assets of the pany onwhich there is a charge. So the unsecured loan stockholders rank after thedebenture holdersOther creditors of the pany rank equally with the unsecured loan stockholders. An exception to this is that some banks have issued subordinated loan stockso that the loan stockholders rank after the banks depositors in the event of a windingup. If (as is usual) there is insufficient money generated from the liquidation of thepanys assets to meet all these claims, what is available is shared out in proportionto the amount owed. For example, 35p in the t"might be paid to all creditors. If thereis a surplus it will be distributed to the pany's shareholdersThus, on a winding-up, high-ranking claimants(eg debenture holders)may well get all oftheir capital returned. Low-ranking claimants(eg shareholders) may get nothing. At thehighest level of ranking at which the total money available is insufficient(eg unsecuredcreditors)a proportionate payment will be madeC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 9RiskThere is no security for the loan, although(as with debentures) payments are a legalbligation on the pany. The rights of unsecured loan stock holders are often set out ina trust deed and looked after by a trustee. If a pany fails to make interest or capitalrepayments when they are due, the loan stock holders can apply to the courts to have thepany wound up. When the pany is liquidated, unsecured loan stock holders willrank equally with other unsecured creditors of the pany (eg customers awaitingdelivery of goods, suppliers awaiting payment)In practice, if a pany has got to the stage of being wound up, its assets are usually oflittle value so unsecured loan stock holders may get little or nothing backReturnGross redemption yields are higher than on debentures to pensate forpoorer marketability and greater risk.The yield margin over government bonds tends to be a little higher than for debenturesin a given pany to reflect the extra risk.MarketabilityMarketability tends to be similar to ddebentures, ie a lot worse than government bondsThe standing of the issuer and the size of issue determine marketability. Againmarketability decreases a few months after a new issueConclusionThe appointment of a trustee and the restrictions on further borrowing which are typicallyfound in a trust deed are designed to reduce the risk to the unsecured loan stock ULSholder. However uls will be less secure than debentures. An unsecured loan stockholder is even more dependent upon the pany's continuing profitability in order tomeet the required payments. Therefore, unsecured loan stocks are considered more riskythan government bonds, local authority issues and debenturesAs with a debenture, payments are a legal obligation on the pany and unsecured loanstock holders are entitled to be repaid fully in the event of a winding-up beforeshareholders can receive anything. Therefore, unsecured loan stock in a pany is moresecure than shares in the same panyThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 10CT2-04: Financial instrumentsQuestion 4. 4Why dont panies always issue unsecured loan stocks rather than debentures?Corporate bonds behave much like government bonds. The major differences betweencorporate bonds and government bonds areorporate bonds are less secure than government bonds. The level of securitydepends on the type of security, the pany that has issued it, and the termCorporate bonds are much less marketable than government bonds, mainlyecause the sizes of issues are much smaller1. 4 Subordinated debtIn the event of default. the holder of subordinated debt ranks below the firmsgeneral creditors(but ahead of preference shareholders and the ordinaryshareholders). The subordinated lender holds a junior debt and is paid after allsenior debt holders are satisfiedSubordinated debt or junior debt is debt over which senior debt takes priorityLenders can assume that they have a senior claim unless the debt agreement saysotherwiseThe rating of the debt and, consequently the terms on which it is issued, willreflect this lower level of security1.5 Eurobond loan capitalDescriptionTraditionally a pany would issue loan stock within the tax and legal frameworkof its own country.However, it is also possible to borrow in another country. For example, overseasborrowers can issue sterling-denominated bonds in the UK bond market. These are calledbulldogs. Similarly UK firms can issue dollar-denominated bonds in the US marketThese are known as Yankee bonds. Foreign bond issues give borrowers access to theinvestors of another countrC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 11Eurobonds go one stage further: they give borrowers access to international investorsA Eurobond is a bond issued in the uromarket. A Eurobond is marketed internationallymainly by the London branches of international banksSince the 1950s it has been possible to arrange with investment banks for loancapital to be issued to investors without it ing under the legal or taxjurisdiction of any country. The market for this type of loan capital is known asthe"Euro"market- although it is not confined to Europe. The main centres for tradingare London and LuxembourgEurobond issues can be made in almost any currency including the euro. Themajority of Eurobond issues are denominated in dollarsCompanies throughout the world raise money by issuing Eurobonds. Governmentscan also issue Eurobonds. Recently, more money has been raised by UK paniesthrough eurobond issues than through the traditional marketsMost Eurobonds are redeemed at par on a set date with fixed coupon paymentsduring the term of the Eurobond. However, coupon payments on Eurobonds areusually made annually rather than six monthly. For example, a 10% Eurosterlinissue would pay t1o every year per f100 nominal heldAlmost all Eurobonds are unsecured Like holders of unsecured loan stocks,Eurobond investors would rank equally with other unsecured creditors if a pany werewound upEurobonds are“" bearer forn” documentsQuestion 4. 5What does "bearer"mean? What form will a security be if it is not"bearerTo claim interest payments, holders must cut out coupons from the certificatesand send them to the pany (or its paying agent). This is one reason whypayments are made annually rather than six monthlyAs with other forms of pany securities, Eurobonds can be held by individualswell as by corporate borrowers. There is a story about belgian dentists holding largeamounts of their investments in this form. The story goes as followsThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 12CT2-04: Financial instrumentsBelgian dentists are paid lots of money and therefore are taxed highly. In order topostpone/avoid/reduce their tax liability (choose whichever option you prefer), it isconvenient for them to hold investments which are not registered but are bearerdocuments. In addition, Belgium is close to Luxembourg, and so it is just a short trainride once a year for the dentists to go and collect their interest, which is paid gross(ieA significant minority of Eurobonds have a variable coupon payment. They areknown as floating- rate notes"(see Section 1.6 below)Many innovative types of Eurobonds have been issued This is because eurobondsare issued with freedom from national regulation. For example, on some issues interestpayments may be made in more than one currencyAlthough most Eurobond issues are listed on a stock exchange(often in London), mosttrading in them occurs through the banks rather than through a stock exchangeEurobonds are also used to raise large sums the minimum acceptable issue is$75m or more. They are not secured against the assets of the issuing panyThe key difference between Eurobonds and unsecured loans is that Eurobonds aremarketed in a different way. A Eurobond is an issue underwritten by an internationalsyndicate of banks and typically(but not exclusively) sold in countries other than thecountry of the currency in which it is denominated. Issues are often marketed in severalcountries simultaneously. Eurobonds are not fully within the legal control of anygovernmentCommon currencies of issue include the US Dollar(which accounts for about 50% ofthe market), the Japanese Yen and Sterling. Issues in these currencies are respectivelyknown as‘ Eurodollar”," Euroyen”and‘" Eurosterling” IssuesRiskThere is no security for the loan. Furthermore, Eurobond issues do not always placerestrictions on the issuing pany's future borrowing powers. Consequently investorsare very dependent upon the profitability and good name of the issuing pany. Ifanything, Eurobond issues are more risky than traditional unsecured loan stock issuesmade by the same pany. However, issuers of Eurobonds tend to be large stablefirms, institutions or governmentsReturnGross redemption yields depend upon the issuer (and hence risk and issue size(and hence marketability Inflation will affect the real return achievedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsThe gross redemption yield on a Eurobond of a given size and issued by a givenpany should be similar to the gross redemption yield on an unsecured loan stock. Inpractice, Eurobonds are often issued by very secure borrowers in large amounts(givingquite good marketability). Therefore margins above government bond yieldsaretypically very low(eg 72%)MarketabilitMarketability is better than debentures and unsecured loan stocks but not usually asgood as government bondsConclusionEurobonds can be issued with either fixed or floating rates of interest, and normallyhave a fixed maturity date They represent a convenient method of raising largeamounts of foreign currency denominated funds without having to enteroverseas financial markets. It may be possible to raise funds at a lower rate ofinterest than is available on domestic currency funds, but there may beassociated exchange rate risks if the funds raised are converted for use indomestic projects1.6 Floating-rate notesMost people are aware of the idea of floating or variable interest rates. Most people'ssavings earn a variable rate of interest and the interest rate on many mortgages in theUK are variable( though elsewhere fixed-interest mortgages are more monFloating-rate bonds are relatively new. They have only been part of the Euromarketsince the 1970s. Many UK borrowers prefer fixed-interest bonds because they knowtheir costs in advance and can plan their cashflows. However, when interest rates arehigh, panies are reluctant to borrow. In the 1970s interest rates were very high andfloating-rate notes became more attractiveFloating-rate notes(FRNs)are medium-term debt securities issued in the Euromarket whose interest payments " float" with short-term interest rates, possiblywith a stipulated minimum rateIt is mon for floating-rate notes to have a minimum interest rate below which thecoupons will not fall even if the benchmark interest rate falls lower. This is known asan interest-rate floorThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 14CT2-04: Financial instrumentsThus, the issuer does not need to estimate the likely levels of future inflation andinterest rates when issuing the notes, and the lender does not require annflation risk premiumIf inflation increases, then short-term interest rates tend to increase. (This relationship isSubject CT7)ng-rate stoworry about future inflation. A pany that issues fixed-interest stock has to estimatefuture inflation in order to give a satisfactory return(after inflation) to the investorsInvestors too need to consider the risk of inflation wiping out the return received froman investment. If they are uncertain about inflation they might demand a higher interestrate as a premium to cover the risk they are takingC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 152 Share capital2.1 Ordinary shares(Equities")DescriptionOrdinary shares give rights to a share of the residual profits of the pany, and to theresidual capital value if the pany is wound up, together with voting rights andvarious other rightsOrdinary shares are the main way in which UK panies are financed. Apany may or may not have loan capital and/or preference shares. However, to existit must have ordinary share capital(unless it is"limited by guarantee")The shareholders are the owners of the business. shareholders will have votingrights at meetings in proportion to the number of shares heldThey wil receive " dividend"'payments made from a pany,'s profits.Dividends are not a legal obligation of the pany. Dividends are only paid atthe discretion of the directors. In practice directors try to pay a steadilyincreasing stream of dividendsDividends are paid net of tax (for example, net of 10% in the UK), with anattaching tax credit for the recipient. This is termed "franked"investmentine. In the UK, the tax credit cannot be reclaimed by the investor and thoseho are subject to a higher rate of tax on dividend ine have to pay additionaltax. this was covered in chapter 3 Section 1.2They hold the equity interest or residual claim since they receive whateverassets or earnings are left over in the business after all its debts are paidOrdinary shares are sometimes called "equities"which, in this context, meansresidual". In other words, holders of ordinary shares are entitled to whatever profit isleft over after other providers of finance have received their interest payments. In mostcases the directors will choose to retain some of the profits attributable to ordinaryshareholders, but if they are invested effectively, the retained earnings should enhanceordinary shareholders' profits in future yearsOrdinary shares are the lowest ranking form of finance issued by paniesOn a winding-up they will rank after all creditors of the pany, eg employees,customers,suppliers, bankers, holders of loan capital and the Inland Revenue. If theallotheny is wound up, ordinary shareholders will only receive any residual assets onceother creditors and preference shareholders have been repaid in fullThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instrumentsThe upside of this residual nature is that there is no upper limit on the size of residuprofits and hence no upper limit on the return which ordinary shareholders could earnOrdinary shares are almost always irredeemable ie there is no fixed date when thepany has to repay the share capitalAll shares have a"par"or "nominal "value, often 25p. the par value has norelevance to the market value of the share Companies are not allowed to issueshares below the par value, although partly paid issues(shares where the investor ismitted to make a further payment of capital to the pany at a later date) areShareholders have a liability up to the fully paid value of the shares. For example, a 25ppar value share issued at a price of 40p may only be 80%"paid up"ie only 32p wasoriginally invested in the pany-the other 8p to be called for at a later date. A holderof a single share would be liable to pay another &p into the pany if it was wound upwith unpaid debtshe accounts of a pany show the nominal value of the issued share capital(number of shares x par value) separately from the rest of the shareholders'interests inthe pany. However, the nominal value shown in the accounts has little practicalsignificanceThe Memorandum of association will set out the total nominal value ofauthorised share capital. This is the maximum amount that the directors can issuewithout calling for a vote from the shareholders above this limit the directors need theshareholders'approval to increase the amount of share capital. The issued sharecapital is the nominal amount actually issued. the issued share capital cannotbe greater than the authorised share capitalAlmost all ordinary sharesgive an equal right to share in residual profits(after the preference shareholders,if any, have received their full entitlement to dividends ) This is the mostimportant feature, and is the main reason for buying sharesgive one vote per sharegive an equal share to any assets left over following a winding-up after all othercreditors have been paidare fully paid (partly paid issues are discouraged by the Stock Exchange)give various other minor rights (eg the right to receive the annual report andaccounts)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 17The low ranking of ordinary shares in terms of payment of dividends and upon windingup makes ordinary shares a more risky investment than other types of capital from theinvestors' point of view. For example, if the pany has a bad year for profits, theremay be no dividend for that yearAs well as having the right to residual profits and assets, ordinary shareholders have theright toattend and speak at pany meetings, or appoint a proxy to attend and vote ontheir behalf (a proxy is not allowed to spealvote to reduce. but not increase. dividendsvote to appoint directorsvote to forego the"pre-emptive right to be offered any new shares to be issuedvote to change the pany's borrowing powersreceive the annual report and accounts and the memorandum and Articles ofAssociationQuestion 4.6a friend says: "Ordinary shares are the most risky form of investment so a prudentinvestor should avoid investing in themComment briefly on this statementVariationsOccasionally some panies issue variations of the basic ordinary sharedescribed above. For exampledeferred"shares which e in two varieties: either no dividends are paiduntil normal ordinary shareholders' dividends or profits reach a given level, orno dividends are paid until a given dateredeemable ordinary shares which will be repaid by the pany at a certainnon-votingshares with multiple voting rights, andgolden"shares in newly privatised industries. Golden shares are thoseheld by the government following a privatisation. These shares give thegovernment certain rights, eg voting rights and veto rights on certain issuesThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 18CT2-04: Financial instrumentsQuestion 4.7Can you think why some panies might end up with non-voting shares?The Stock Exchange discourages the issue of"non-standard"ordinary sharesThe theory of risk and expected returnMuch of what you will learn in the actuarial syllabus is based on the Capital AssetPricing Model and the assumptions that form the basis of this model. The fundamentalprinciple is one of risk and return which is critical to this course, and to some of the latercourses you will meet such as Subject Ct&, CAl and St5In brief we assume that any rational investor making an investment decision will firstdecide what return they require from a particular investment. This required return willbe influenced by the investors perception of how risky the investment is-therisk, the more return he or she will require. For most rational investors(otherowners of football clubs) the risk of loss or the uncertainty attached to the amount andtiming of future payments would lead them to be less inclined to invest in the securityConsequently such securities generally trade in the market at prices which offer theinvestor a higher return to pensate. Risk is often defined in terms of the volatility ofthe expected returns from the investment, partly because it fits with the general feelingamong investors and partly because it allows rather tidy results to flow from theanalysis.The investor will then determine a price for the asset such that the expected return fromthe asset at the specified price gives a return at least as high as the required returnConsidering ordinary shares, the expected return on the investment will be influenced bytwo thingshow much ine yield (or dividend yield "for equities) she expects to receivehow much capital growth she expects to obtain from holding the share over acertain periodThe first of these ponents is linked to the price at which the asset is purchased. If wedefine the net dividend yield asnet dividend persharewe can see that the higher themarket price per sha.price paid, the lower the dividend yield from the investment(the net dividend paid by apany does not alter when the market price of the share changes)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsThe second ponent is equal in theory to the growth in the dividend. The determinationof the share price is covered in CTl. It is assumed that the share price is the present valueof the future dividend streamSo an investment in an ordinary share will bring the investor a dividend yield and capitalgrowth. The sum of these should be sufficient to give a return equal to or greater than therequired return he or she calculated at the very start of this process. Although the totalreturn from holding an equity share will usually be greater than the return available onloan capital, the dividend yield on its own is usually lower than the gross redemption yieldavailable on loan capitalRiskWhen panies are wound up, ordinary shareholders often end up with nothing as theyrank below creditors and usually rank below preference shareholders (althoughsometimes preference shareholders and ordinary shareholders rank equally on windingup). So, ordinary shares in most panies are riskyRisk can often be thought of in two ponentsthe uncertainty and volatility of the future ine streamthe uncertainty of capital return in the event of a winding-upAs ordinary shares offer both of these in large quantities, they can be classed as higlriskReturnOrdinary shares offer investors high potential returns for high risk, particularlythe risk of capital lossesThe initial running yield(that is, the rate of ine the share will produce at itcurrent market price) is low but dividends should increase with inflation and realgrowth in a pany's earnings. Historically, equities have given the highestreturn of any of the main asset classes over the long term. Because of thinvestors have been prepared to accept the high variance of return which canlead to poor short-term performance even for a well diversified portfolioIne from ordinary shares is a form of franked investment ine(as described inChapter 3 of the course)The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instrumentsMarketabilityMarketability of ordinary shares varies according to the size of the pany butis usually much better than for the loan capital of the same pany.There are three main reasons for this:For many panies, the bulk of their capital is in the form of ordinaryshares. So issues of ordinary shares tend to be large(ii) Most panies only have one type of ordinary share whereas their loancapital is likely to be fragmented into several different issues(iii) Investors tend to buy and sell ordinary shares more frequently than theytrade in loan capital because the residual nature of ordinary shares makesthem more sensitive to changes in investors'views about a pany.In other words, if an investor has a view about the likely future profits growth of apany she should express that view by buying or selling the ordinary shares. Anyincrease or decrease in the profits of the pany will flow through directly to theshareholders, whereas increasing profitability will influence only the security of thebond payments, not the amount of the paymentsConclusionOrdinary shares offer investors the potential for high returns but shareholders take agreat risk. Dividends can be volatile, as can the market values of the shares. Ordinaryshareholders rank last in the event of a winding-upes are usually highlymarketable2.2 Preference sharesDescriptionPreference shares are much less mon than ordinary shares. Overallpreference shares are much less important than ordinary sharesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 21The investment characteristics are more often like those of unsecured loan stocksthan ordinary shares. Assuming that the pany makes sufficient profits, theyoffer a fixed stream of investment ine(which is paid net of tax, like dividends)Preference shares pay a fixed dividend and so can be regarded as a form offixed-interest stock. The dividend is usually expressed as a fixed percentage of thepar value, so when we refer to the "dividend" from preference share it is more akin to aninterest payment on a bond than to a dividend on an ordinary share. They do notusually carry voting rights.Preference shareholders have a preferential right to either dividends, or return ofcapital, or both, pared to ordinary shareholdersDividends do not have to be paid. However, if dividends are not paid onpreference shares, no ordinary share dividends can be paid. It is usual for thepreference shareholders to get voting rights whilst their dividends remainunpaid. Preference shareholders also have the right to vote if the rightsattaching to their shares are being variedThe crucial difference between preference shares and ordinary shares is thatpreference share dividends(except for participating shares)are limited to a setamount which is almost always paidMost preference shares arecumulativeirredeemableCumulative preference shares require any unpaid arrears of dividends, as well asthe current year's dividend, to be paid before any dividend can be paid to ordinaryshareholdersVariationsHowever, preference shares may also benon-cumulativeredeemableparticipatingconvertiblesteppedThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instrumentsParticipating shares are entitled to a share of the profits on top of the fixeddividend, once the ordinary share dividend exceeds a certain amount.Stepped shares have a dividend that increases in a predetermined way.Question 4.8List the possible varieties ofpreference share(ii) ordinary shareQuestion 4.9Briefly pare a preference share to an unsecured loan stockRiskPreference shares rank below loan capital and above(or equal to) ordinary shares if thepany Is wound upIn a given pany, the risk of preference shareholders not getting their dividends isgreater than the risk of loan stockholders not being paid, but less than the risk ofordinary shareholders not being paid. This is valid both for the dividend paymentsduring a difficult period, and for the repayment of capital in the event of a winding-upThe variability of return will only be a little greater than for loan capital. Preference sharesoffer a relatively predictable future ine stream, but uncertainty about the return ofcapital in the event of a winding-up. However, the variability of return will besignificantly less than that of ordinary shares, because a preference share's capital valuewill fluctuate much less than the capital value of an ordinary shareReturnIf there were no tax plications, the expected return on preference shares would be alittle greater than the expected return on loan capital for all shareholders. However, thereis a tax plication, as the following example showsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsExampleFor this question, you may assume thatInterest payments are made annually in arrearsno tax is payable on net dividend inethe discount rate for valuing the cashflows is 10%(1 Calculate the value of the following stocks to an individual paying 20% ine(a) an irredeemable loan stock paying 10% per annum(b) an irredeemable preference share paying a net dividend of 7.5%(ii) Repeat the above calculation for a pany paying 28% corporation taxSolution(i Individual paying 20% ine tax(a) For a holding of f100 nominal, the individual receives net interest payments of f8per year(after the deduction of tax@ 20%). The value of these payments8×(v+y2+y3+.)=8a=f80(b) The investor receives net payments of f7. 50 per t100 of preference shares heldThe value of these payments will be f75.00(i Company paying 28% corporation tax(a) The calculation proceeds as above for the loan stock, however we must alsoconsider the extra tax(28% rather than 20%) the pany has to pay on the netine. The value of this net cashflow to the pany is10×0.72(v+y2+y2+…,)=72a=£72(b) The pany receives net payments of t7. 50 per f100 of preference shares heldThe value of the ine stream to the pany is therefore f1f nceThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 24CT2-04: Financial instrumentsRemember from Chapter 3, that since dividend ine is franked ine (ie paid frompanies'post-tax ine) the government might choose to give shareholders at leastsome credit for the tax that has already been paid. In the case above, it is assumed thatshareholders are required to pay no more tax on dividend ineAs can be seen from the above example, the tax treatment can have an effect on thevalue of the stock to different investors. In particular, panies might prefer to investin preference shares rather than loan stock, because they pay no more tax on the netdividends received, whereas they pay 28% tax on gross interest receivedFor most investors, preference shares offer a lower after-tax return than loancapital. However, for corporation tax payers preference shares can sometimesoffer a higher net return than the net return available on loan capitalAs discussed above in the case of ordinary shares, any increased uncertainty relating tothe payment of dividends or the repayment of capital is likely to make the share lespopular to investors. As such, you would expect that preference shares are likely tohave to offer a higher expected return than loan stock. This is generally true forvantageg In prerather than loan stock(as shown in the last example). This tax advantage means thatpreference shares are popular with corporation taxpayers, forcing their price up andmaking them unattractive for other investorsFor all investors, the expected return on preference shares is likely to be lessthan on ordinary shares because the risk of holding preference shares is lessMarketabilityMarketability of preference shares is similar to loan capital marketabilityConclusionPreference shares offer the investor a lower risk than ordinary shares and therefore earna lower rate of return. Since the risk of holding a preference share is higher than the riskof holding loan stock, the return is higher than that received on loan stock. Preferenceshares are a particularly attractive form of investment for panies because of thepreferential tax treatment of dividends pared with interest on loan capitalC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsQuestion 4.10Complete the following table paring ordinary shares with preference sharesordinary sharespreference sharesVoting rightsDividendsImportance for panyDifferent varietiesPriority on winding up the panyThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instruments3 Other types of long-term financeThere are many other types of finance that straddle the divide between debt and equityfinance. We shall look at the main types of these hybrids3.1 ConvertiblesDescriptionConvertible forms of pany securities are, almost inbly, unsecured loanstocks or preference shares that convert into ordinary shares of the issuingpanyConvertible preference shares are preference shares which give the right toconvert into ordinary shares at a later date. the investor does not pay anything toconvert other than surrendering the convertible preference sharesConvertible unsecured loan stocks are unsecured loan stocks which give the rightto convert into ordinary shares of the pany at a later date. For example, t100nominal of convertible unsecured loan stock might be convertible into, say, 30 ordinaryshares on l st October 2012The only difference between convertible loan stocks and convertible preference sharesthe form of the capital before it converts into equity. Convertible loan stocks are part ofloan capital until conversion, whereas convertible preference shares are part of sharecapitalThe convertible loan stock will have a stated annual interest payment(paid intwice-yearly instalments ). For convertible preference shares, the stated rate willbe in a similar format to dividends ( For example in the uK the rate will be netof a 10% tax).In respect of capital gains, all convertibles are non-qualifying and therefore taxmay be payable. Loan stocks provide gross ine, (ie ine that has not beentaxed) and preference shares provide ine in the same format as dividendsConvertible stocks have several advantages over oapital and ordinaryunsecured loan stocks, both from the issuer's and from the investors point of viewThey are popular in the United States as a form of finance for new panies. Thesepanies have no track record and might find it difficult to raise funds in moreconventional waysC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsInvestors have the security of a fixed return in the short term and the possibility of long-term capital gain if they convert to ordinary shares in the futureThis additional prospective return means that the issuer does not have to offerexcessively high rates of interest on the loan stocks in order to attract lendersFollowing conversion the shareholder will receive an ordinary share certificate to replacethe convertible preference share or loan stock certificate. The shareholder then stopsreceiving preference dividends or interest payments and instead starts receiving whateverordinary share dividend is declaredIf the holder chooses not to convert, then the security might continue as a loanstock or preference share for a period of time known as the stub. Alternatively itmight be redeemed on a prescribed basis immediatelyConversion dates and termsThe dates and terms of conversion are specified at the time of issue. There will be aspecified number of ordinary shares for each convertible. The date ofconversion might be a single date or, at the option of the holder, one of a seriesof specified datesThe following examples illustrate the range of possible conversion termsExamplesFixed date and fixed termsEach convertible 8%(net) irredeemable preference share may be converted into anordinary share on 1 July 2008Variable dates and fixed termsEach convertible preference share may be convertible into 2 ordinary shares on any 1stJanuary between 2008 and 2013. It is up to the investor to choose when(and whether )toconvert between these datesVariable dates and variable termsEach convertible preference share may convert into 2 shares if conversion takes place on 1January 2008, 2.5 shares if conversion takes place on I January 2009, 3 shares ifconversion takes place on 1 January 2010 etcThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instrumentsThe conversion terms are always revised following a capital restructuring such as a scripsue or a rights issue- these are described later in the course.The period prior to the first possible date for conversion is known as the restperiod. The period during which conversion may take place is, not surprisingly, knownas"the conversion periodConversion premiumAt any time, the cost of obtaining one ordinary share by purchasing the requirednumber of convertible securities and converting can be pared with themarket price of the share the difference is known as the conversion premiumQuestion 4.11GHI plc issues f500, 000 of convertible loan stock. Holders will have the option toconvert each t5.00 of stock into 4 ordinary shares on 1 January 2010. The current shareprice is 86P, and the loan stock is trading at parCalculate the conversion premiumInvestment characteristics prior to conversionThe characteristics of a convertible security in the period prior to conversion area cross between those of fixed-interest stock and ordinary shares. As the likelydate of conversion (or not gets nearer, it bees clearer whether theconvertible will stay as loan stock or bee ordinary shares. As this happens,its behaviour bees closer to that of the security into which it will convertThere will generally be less volatility in the price of the convertible than in theshare price of the underlying equity, because the dividend payment is fixed and doesnot depend to the same extent on the short-term profits growth of the panyThe security of dividend payments for a convertible is higher than that of an ordinaryshare, and the option to convert to an ordinary share or leave it as a fixed-interestsecurity allows the investor to be sure of a minimum expected returnC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsReturnBecause convertibles do not benefit from the dividend growth enjoyed by ordinaryshareholders, convertibles generally provide higher ine than ordinary sharesConversely, because they do offer the prospect longer term of benefiting from thegrowth of the dividends, convertibles will provide a lower ine than conventionalloan stock or preference sharesMarketabilityThe market in convertible stock is not large in the UK. In the US, convertibles are auseful form of finance for the many new businesses that set up each yearConc/usionFrom the investors point of view, convertible securities offer the opportunity tobine the lower risk of a debt security with the potential for large gains of anequity. The price paid for this is a lower running yield than on a normal loanstock or preference share.3.2 WarrantsWarrants are call options written by a pany on its own stock(See Chapter 5 for further discussion of options. )The purchaser of a warrant hasthe right but not the obligation to buy a fixed number of the pany's shares at a fixedprice at a fixed dateWhen they are exercised, ie when the purchaser exercises his/her right to buy theshares, the pany issues more of its own shares and sells them to the optionholder for the strike price. Thus, the exercise of a warrant leads to an increasein the number of shares that are outstanding This, in turn leads to somedilution in the value of the equityWarrants are often added to the issue of a fixed-interest bond to make it moreattractive to investors -a significant proportion of private placement bonds, (iethose bonds sold directly to a small number of lenders such as banks, insurancepanies and pension funds) are sold with warrants. Warrants are also oftengiven to investment banks as pensation for underwriting services or used topensate creditors in the case of bankruptcy. Investment banks issue shares onbehalf of panies and agree to buy any shares that are not sold to the general publicie they underwrite the share issue. We shall look at the issue of shares in Chapter 6The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instrumentsThe warrant holders are not entitled to vote or receive dividends but theexercise price of the warrant is automatically adjusted for any share dividendsor share splits. For example, if the pany doubles the number of shares anddistributes two new shares for every one share held then it will also doublee numlof warrants and halve the exercise price.(A share split is known as a scrip issue in theUK. We shall study scrip issues in Chapter 6)Typically, a warrant lasts for a number of years. Once they have been created,they sometimes trade separately from the bonds to which they were originallyattached3. 3 Options issued by paniesIn addition to warrants and convertibles the main class of option issued bypanies are executive stock optionsThese are, effectively warrants issued to senior managers as part of theirremuneration package, with strike prices that are intended to represent aperformance target for the executiveAs noted in 3. 2 above, the effect of issuing such instruments is to dilute thevalue of the equity already in issue. Increasingly, firms with significant amountsof warrants (or convertibles) outstanding are required to report earnings on afully diluted"basis. This recognises the potential increase in the number ofsharesShareholders are interested in the earnings of the pany, ie the profit after tax that isavailable for distribution to the shareholders or for ploughing back into the businessTotal earnings may not mean very much to a shareholder but earnings per share showshow much after-tax profit has been generated per share. If the number of shares is likelyto rise because of obligations that the pany has entered into, such as convertibleswarrants and stock options, then the diluted earnings per share can be calculated. Thiassumes that all options are exercised in full and therefore gives afully-diluted "figureWe shall look at various ratios for analysing the performance of panies in Chapters12 and 13C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 314 Winding up a panyTo help explain the contents of this chapter and of Chapter 2 it is useful to consider thehypothetical winding-up of a panyImagine the ABC Company plc. The pany makes widgolets, a ponent required bythe widget-making industry. The pany has issued both share capital, includingordinary and preference shares, and loan capital: some fixed-charge debentures secured onthe pany's factory, and an unsecured loan stockThe pany has borrowed money from the bank using a flexible loan facility. It has alsopushed its overdraft to the limit. The pany has trade credit agreements with itssuppliers and is buying some machinery on hire purchaseThe pany has had a bad year owing to a recession, which has hit the widget industryparticularly hard. Its profits are down to such an extent that it is unable to pay theinterest on the unsecured loan stock, although the debenture interest payments are madein fullThe unsecured loan stock holders have a meeting and decide to sue the pany. Theirclaim is successful and the court orders the pany to be wound up. The assets aresold and the various lenders receive payment as follows1. The hire purchase pany repossesses its machineryMortgage debenture holders receive payment from the proceeds of the assetscharged to them ie the factory this is not necessarily a fort to them If thewidget industry is in serious decline, the factory and its contents(widgolet-makinmachinery) may be almost worthlessFloating-charge debenture holders (together with fixed-charge debenture holdershould the fixed charge prove to be insufficient) have first claim to the remainingassets. As soon as the court decides that the pany should be wound up, thefloating charge is crystallised into a fixed charge4Employees receive any arrears in their wages the employees of a pany havefirst call on the panys assetsOther creditors e next. This includes the bank and the trade suppliers and567unsecured loan stock holdersIf anything is left, preference shareholders are paid nextOrdinary shareholders will receive whatever is left after the rest of the claimantshave been paid. As you can imagine, this may not be very much. Often it will beThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 32CT2-04: Financial instrumentsQuestion 4.12Distinguish fully between(a) par value and market value of shares(b) authorised and issued share capital(c) preference shares and ordinary sharesan capital and ordinary share capi(e) fixed and floating charges(f debentures and unsecured loan stocks(g Eurobonds and traditional forms of UK loan capitalQuestion 4.13True or false?(a) Government bonds are more marketable than debenture stock(b) Eurobonds are more marketable than ordinary shares(c) Debentures provide a higher return than unsecured loan stock(d) Convertible loan stock generally provides a lower ine than conventional loanstock(e) Ordinary shares generally provide a higher ine than convertible preferencesha(f Warrants are a form of loan stock(g) Executive share options are a form of warrant(h) Eurobonds are less risky than debenturesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsIn the past, exam questions have expected you to be able to describe the features anddiscuss the relative merits for an issuer and for an investor of all the different types oflong-term finance. For example:Describe the main characteristics of ordinary shares and explain why ordinary sharesare more marketable than loan capital. ( April 2001 adapted)You should discuss the key characteristics of risk, return, marketability and rights ofownership. Marketability is high because of large issues, standard issues and frequenttradingThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instrumentsThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsChapter 4 SummaryLong-term financeLong-term pany finance can be classified as share capital and loan capitalOrdinary shares are the most mon type of share capital. They give rights to a shareof the residual profits of the pany, and to the residual capital value if the pany iswound up, together with voting rights and various other rightsPreference shares give their holders a preferential right to dividends and return ofcapital, pared to ordinary shareholders. Preference shares pay a fixed dividendThey normally give voting rights only when dividends are not declaredConvertible preference shares are one variety of preference shares. They give holdersthe right to convert their preference shares into ordinary shares on fixed terms on certaindatesHolders of share capital are members of the pany. Holders of loan capital arecreditors of the pany. They do not have voting rights. They receive interepayments which are a cost to the pany, not a distribution of profits. Interestnormally paid twice a yearDebentures are loans which are secured on some or all of the assets of the pany.They are regulated by a Trust Deed which is overseen by a trustee. Debentures may besecured by a fixed charge on specified assets, or by a floating charge across a class ofWith unsecured loan stock there is no specific security for the loan. Convertibleunsecured loan stocks give their holders the right to convert into ordinary shares of thepany at a later date. Subordinated debt is junior debt and is paid after all senior debtholders are paidA Eurobond is a form of unsecured loan capital that is issued outside the legal and taxjurisdiction of any country. It is a bearer document, paying interest normally once ayear. Interest is paid gross. It may pay a variable rate of interest, in which case it isknown as a floating-r'ate notea warrant is a call option written by a pany on its own stock. The owner of thewarrant has the option to buy a fixed quantity of the pany's shares at a fixed price ata fixed date. Executive stock options are effectively warrants issued to senior managers,with strike prices that are intended to represent a performance target for the managersThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instrumentsThe various forms of pany capital differ in many wayRiskDebentures are the most secure form of pany capital, being covered by a floatingcharge over the pany's assets or a fixed charge on a specific asset. Eurobonds andunsecured loans follow debentures-they have a prior right to profits before preferencecapital or equity, which are last on the list in that order. Convertible shares or loanstock will be as risky as the corresponding preference share or loan stock until it isconverted into equity, at which point the riskiness increasesReturnInvestors expect a higher return for accepting higher risk. As such the expected returnfrom each form of capital is in reverse order to the list for risk, namely(highest tolowest): equity, preference, unsecured loans, Eurobonds, and debentures. The actualcost to the pany will be equal to the return achieved by the investor(ultimately),however the immediate cost to the pany of servicing the capital is higher for debtthan for equityMarketabilityEquity is the most mon form of pany capital, and is as such the mostmarketable. The marketability of the other forms depends very much on the size of theissue (which usually favours Eurobonds)and the credit rating of the borrower, asassessed by an independent agencyMost forms of pany debt have the advantage that interest payments are deductedfrom pre-tax profits and so help to reduce the tax charge. Coupons are paid gross to theinvestor. Preference shares however pay franked ine, which is deducted from thepany' s ine statement after the tax line and paid net of tax toThtax treatment can be beneficial to various types of investor, and can reduce the cost ofthe borrowing for the panyC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 37Chapter 4 SolutionsSolution 4In each of the years 2007 to 2017 inclusive, you would receive 6% of t200=fl2. Thwould normally be paid in two semi-annual payments of t6. This amounts to f132. Atthe maturity of the bond you would get f200 back in addition to the final couponpayment we have included above. Total cash received =t332Solution 4.2If interest rates rise general in the economy, the fixed interest on the bond paresunfavourably with that received elsewhere. The demand for such bonds will thereforefall and the price will fall. As the price falls, the fixed interest bees a higherpercentage of the market price and the capital gain(if any)on redemption increases untilequilibrium is restoredSolution 4.3Typical issues covered in a trust deedDescription of any assets of the pany that might be set aside to cover theparticular loan in the event that the pany winds upDetails of exactly how the assets should be used to repay the bondholders in theevent of a winding-up and how surplus cash should be treatedThe rights of the pany to issue further bonds that rank above or alongsidethis particular issueCovenants that describe how much the panys profit must remain above theamount of the interest payments on the bond. This is a form of protection forbondholders to ensure that their interest payments are easily met by the panyArrangements for changing the trusteesa description of circumstances under which bondholders must be consulted. Forexample if covenants are breached or about to be breachedThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instrumentsSolution 4. 4Debentures are secured upon the assets of a pany. This security means that thepany can offer a lower rate of coupon(ie interest) to investors. The pany willtherefore find it cheaper to borrow using debentures than using unsecured loan stockSolution 4.5This means that the issuing pany does not keep a register of holders, unlike sharecapital and traditional loan capital. So, holding the Eurobond loan certificate is proof ofownership. Rather like a pound note- if you lose it, you ve lost itIf a certificate is not bearer, it is normally"registered"which means that your name ison a puter list somewhere, and if you lose your certificate, the registrars can issueou with another one. dividends can be transferred directly to your bank accountSolution 4.6It is true that ordinary shares are potentially risky in that the return from them may bevery volatile(and uncertain). However, an investor would expect, on average, to gain ahigher return from shares than from other investments, to pensate for the higherlevel of riskIn the long term, dividends and share prices should increase in line with inflation andreal economic growth. Therefore shares are a suitable investment for an institutionwhich requires a return linked to inflationAlso, holding a diversified portfolio of shares can help to reduce risk.Solution 4.7Non-voting shares often arise when a family-controlled pany needs to raise morecash, but does not want the loss of control (and potential take-over) that es with itThey therefore issue non-voting shares for the general public, and retain the votingshares themselveC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsSolution 4.8I ypes of preference sharecumulative/non-cumulatiyredeemanticipatingconvertibleTypes of ordinary sharedeferred where no dividends are paid until after a certain time perioddeferred where no dividend is paid until profits reach a certain levelredeemableotisSolution 4.9Both have a fixed coupon, expressed as a percentage of the nominal amount. Howeverthe preference share percentage will be a net percentage, and the investor will get thispercentage of"franked"ine. Companies and basic rate taxpayers in the UK will nothave to pay further tax. On a loan stock the coupon will be paid gross and further taxwill have to be paidPreference shares can be redeemable but are normally irredeemable. Loan stocks can beirredeemable, but are normally redeemablePreference shares normally carry the right to vote if dividends have been passed. Loanstock holders only have the right to wind up the pany and try to recover their lossesOn a winding-up, a loan stockholder will rank above a preference shareholder.The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instrumentsSolution 4. 10Ordinary sharesPreference sharesVoting rightsusually one vote per share only under certaincircumstances. such as nonvariation of rightsDividendsvariable: paid out of residual fixed dividend: paid beforeofitsordinary dividendsImportance for pany very important-form the not very important-a veryfinancingbulk of cearesmall proportion of totalcapitalshare capitalDifferent varietiesdeferred(2 types),nonnon-cumulativevoting, redeemableltirertible, steppedPriority on winding up the paid after all other creditors paid after all creditors butpanyand after preferencebefore ordinary shareholdersSolution 4.11First we need to find the effective conversion price. This is the price an investor paysfor a share by buying it via the convertible, rather than on the cash market. The stock istrading at par and so f5 of stock costs f5Effective conversion price 000The conversion premium is the effective conversion price minus the current share priceSo here the conversion premium =125 -86=397C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 41Solution 4.12(a) Par value and market valueThe par value of a share is a unit of account with little significance other than therestriction that shares cannot be issued for less than their par value. The nominal valueof a pany's share capital is found by multiplying the par value of its shares by thenumber of shares in issueThe market value of a share is what it would actually sell for in the open market. Itsually bears no relation whatever to the par value of the share. The market value canchange from minute to minute as trading takes place. The par value, however, is fixedand cannot normally be changed(b) Authorised and issued share capitalThe authorised share capital of a pany is stated in the Memorandum of AssociationIt is expressed as a nominal value, ie x shares of y par value. The value stated is themaximum amount that the directors can issue without the approval of the shareholdersof the panyThe issued share capital is the nominal amount that has actually been issued. It cannotbe greater than the authorised share capital(c) Preference and ordinary sharesPreference shares pay a fixed dividend. Ordinary share dividends vary depending on thelevel of profits made by the pany.Preference dividends must be paid before an ordinary dividend can be paid. There is nosimilar obligation for panies to pay ordinary dividendOrdinary shares will (normally) carry the right to vote. Preference shares do notnormally have this right, unless either a) a preference dividend is not paid, or b) thepany is proposing to alter the rights attaching to preference sharesThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instruments(d) Loan capital and share capitalHolders of loan capital are creditors of the pany. They receive interest paymentswhich are a cost to the pany, not a distribution of profits. Loan capitalredeemable, often after 10 to 20 years. The interest payments and redemption terms arefixed at the outset of the loan. Loan capital may be secured on the assets of thepany, which may be sold in the event of defaultHolders of share capital are members of the pany, ie they own the pany. Theyreceive dividends which are variable, and which are paid out of the profits of thepany. Shares are not usually redeemable. Share capital is not secured on the assetsof the pany, although the shareholders do have a right to the residual value of thepany on a winding-up- but only after all the creditors have been paid(e) Fixed and floating chargesA fixed charge means that the loan is secured against specific named assets. If theproceeds used to reimburse the eng Capital payments, the assets can be sold and thepany defaults on interestA floating charge means that the loan is secured on the general assets or a class of assetsof the pany. No specific assets are named in the trust deed. The pany can sellor alter its assets, as long as the replacement assets are satisfactory for the lenders(ie ofa sufficient value to cover the amount of the loan). If the pany defaults, a floatingharge will"crystallise"and the assets must be sold to repay the lenders(f) Debentures and unsecured loan stocka debenture is a loan to a pany which is secured on the assets of the pany. Itmay be secured by a fixed charge or a floating charge. If the pany defaults on itspayments, the assets covered by the charge will be sold and the proceeds used toreimburse the debenture holders. The rights of the debenture holders will be set out in aTrust Deed, which is overseen by a trusteeAn unsecured loan stock will not be secured on any of the panys assets. It may begoverned by a Trust Deed. If the pany defaults, the only remedy available to theloan stockholders is to sue the panyC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-04: Financial instrumentsPage 43(g) Eurobonds and traditional loan capitalEurobonds are issued outside the legal and tax jurisdiction of the country in whosecurrency they are denominated. They are traded on the international markets. They mayhave fixed or variable rates of interest. If the interest paid is variable, the issue is knownas a floating-rate note". Eurobonds are bearer documents. They are normallyunsecured. Coupons are normally payable annually, without deduction of taxTraditional UK loan capital is issued in the uK and may be traded on the London stockExchange. Fixed interest rates are the norm(although a very small number of issueswith variable interest rates have been made). The issuing pany will keep a registerof loan holders. Traditional UK loan capital is often secured on the issuing panyassets. Coupon payments are typically made twice a yearSolution 4.13(a) True. Marketability of debentures is lower than the marketability of governmentbonds because the debenture issues are smaller. trading in a particulardebenture can be infrequent(b) False. Ordinary shares are the most mon form of pany finance and arethe most marketable. eurobonds are usually more marketable than other formsof debt finance because they are issued in larger amounts and are activelymarketed by ba(c) False. Debentures provide a lower return because they are the more secure formof pany finance. Holders of unsecured loan stock take a greater risk and thusrequire a greater reward.(d) True. Convertible loan stock generally provides a lower ine thanconventional loan stock because convertibles offer the prospect of dividendgrowth in the future. Investors are attracted by the prospect of dividend growthin the future and are thus willing to accept lower ine in the short term(e) False. Convertible preference shares generally provide a higher ine thanordinary shares because convertibles do not at present offer the benefit ofdividend growth. An ordinary shareholder is willing to accept a lower ine inreturn for dividend growth, whereas the holder of a convertible cannot reap thebenefit of dividend growth at present and would require a higher ineThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-04: Financial instruments(f False. Warrants are not a form of loan stock. They are call options written by apany on its own stock. They are often added to a fixed-interest bond tomake it more attractive to investorsg) True. Executive share options are options to buy the panys shares. Theyare issued to senior management as part of an incentive package(h) False. Debentures are secured on some or all of the assets of the panyEurobonds are a form of unsecured loan stock and rank after debentures in awind-upC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-05: Use of derivativesPage 1Chapter 5Use of derivativesSyllabus objective(v) Demonstrate a knowledge and understanding of the characteristics of theprincipal forms of financial instrument issued or used by panies and theways in which they may be issued.3. Describe the characteristics and possible uses by a non-financial pany offinancial futuresoptionsinterest rate and currency swaps0 IntroductionSubject CtI covers the basics of the most mon derivative products. This chapterconcentrates on the use of derivatives by non-financial panies The two aims of thischapter are(i to show how derivatives serve a real purpose in the mercial world, rathethan being abstract financial products of use only to the financial world(ii to broaden the students knowledge of the derivatives themselvesThe chapter is divided into three sections. We look at financial futures in Section 1options in Section 2 and swaps in Section 3In the past, the examination has tested knowledge of the features of derivative productsand the ability to apply an appropriate derivative product to a particular situationThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 2CT2-05: Use of derivatives1 Financial futures1.1 IntroductionDefinitionA futures contract is a standardised exchange tradable contract between twoparties to trade a specified asset on a set date in the future at a specified priceFutures were originally developed for agricultural and other modities. Chicagodeveloped an important market in the trading of wheat, pork belly and coffee futuresGold, silver and copper soon developed their own futures markets. Financial futuresare based on an underlying financial instrument, rather than a physicalmodity. Financial futures were invented in 1972 and within a few years, trading infinancial futures exceeded trading in modity futuresRemember to distinguish between futures and forwards.(Knowledge of forwards is notrequired for the CT2 exam ) A forward is an agreement between two parties to trade aspecified asset at a set date in the future at a set price. For example, a UK panycould contract to buy a certain type of bond at a set price at a set date in the future. Thisis a two-party deal, tailor-made to suit the two parties, and the pany cannot sell thiscontract to anyone else. Futures differ from forwards in that futures are standardisedand tradable. If the UK pany had bought a future, it would be a standardisedcontract(ie not tailor-made)that could be soldFutures contracts are dealt with on the london intenational financial futures andOptions Exchange(Euronext liffe)in the UK, and the London Clearing House actcounterparty to every trade.CategoriesThey exist in four main categoriesbond futuresshort interest rate futuresstock index futurescurrency futuresIndividual stock futures are also now available on some marketsWe will look at these in more detail in the next sectionC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-05: Use of derivativesPage 3MarginsWhen you enter into a futures contract to buy or sell an asset, the price is fixed today butpayment is not made until later. For example, you might agree to buy a bond future atE94,000 in three months'time. You pay nothing now, but each party to a futurescontract must deposit a sum of money known as margin with the clearingouseMargin payments act as a cushion against potential losses which the partiesmay suffer from future adverse price movements.the contract is first struck, initial margin is deposited with the clearinghouse. For example, you(and the other party to the future) might be asked to payinitial margin of t500.Additional payments of variation margin are made daily to ensure that theclearing houses exposure to credit risk is controlled. This exposure canincrease after the contract is struck through subsequent adverse pricemovements. For example, if the price of bond futures fell to f93, 000 the followingday, then you as the buyer would have made a loss of f1, 000, whereas the supplierwould have made a profit of f1, 000. You as the buyer would pay the clearing housee1, 000 and the clearing house would pay the seller f1,000In this way, the clearing house protects itself by settling up profits and losses each dayIn effect, the futures positions are"closed out every day and a new contract is made. Ieffect, in the example above, after the first day, the seller has an obligation to providethe bond future at f93.000Shortly before the contract is due to expire, the buyer and the seller normally close outthe futures position, ie neutralise existing contracts by entering into equal but oppositecontracts, and the clearing house returns the initial margin. For example, having enteredinto a futures contract to buy a bond in three months'time, the position could be closedout the day before expiry by entering into a futures contract to sell the same bond in oneday's timeQuestion 5.1Why is it necessary for the exchange to require that panies trading futures contractsdeposit a margin when they trade?The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 4CT2-05: Use of derivativesIn financial futures, "delivery"rarely takes place- most deals are"cash settled". In theexample above, the bond is unlikely to be delivered- profit or loss is made by themovements in the price of the bond future and is realised through the variation marginpayments, as shown in the example above1.2 Types of futuresBond futuresFor delivery, the contract requires physical delivery of a bond. If the contractwere specified in terms of a particular bond then it would be possible simply todeliver the required amount of that stock. If the contract is specified in terms ofa notional stock then there needs to be a linkage between it and the cashmarket. The bonds which are eligible for delivery are listed by the exchange.The party delivering the bond will choose the stock from the list which ischeapest to deliver The price paid by the receiving party is adjusted to allow forthe fact that the coupon may not be equal to that of the notional bond whichunderlies the contract settlement price.Examplea bond future might have the following featuresLong Bond FutureUnit of trading: f100, 000 nominal value government bond with 6% couponDelivery monthMarch, June, September, DecemberQuotationper f100 nominalThe settlement of such a future involves buying or selling a prescribed nominal amountof an actual government bond(the amount being determined by certain rules)on theexercise date. The result is that the future trades very much like the basket ofunderlying deliverable assets, and can be treated as a bond itself.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-05: Use of derivativesPage 5Short interest rate futuresExampleThe 3-month interest rate futureThis is based on an artificial index which is defined asIndex=100(4 x the implied 3-month interest rate expressed as a percentage)For example, if the implied (ie the rate that investors expect at the expiry of thecontract)interbank 3-month rate were 2%(or 8% pa), then the index would stand at 92An investor can buy or sell this index as if it were a normal asset. Indeed, being anexchange traded contract, he can sell it before he has even bought it(known as goingshort of the index) and provided he buys it back before expiry he need never deliver itThis is very mon.The price is stated as 100 minus the 3-month interest rate. For example, with aninterest rate of 6. 25% the future is priced as 93.75.The way that the quotation is structured means that as interest rates fall theprice rises, and vice versa. If interest rates fall to 5%, the price of the interest ratefuture rises to 95. This means that the see-saw relationship between price and interestrates applies to interest rate futures as well as bonds. (We saw this relationship appliedto bonds in Chapter 4.)The contract is based on the interest paid on a notional deposit for a specifiedperiod from the expiry of the future. For example, on Euronext liffe, the nominalsize of a sterling interest rate future is f500,000. However no principal or interestchanges hands. The contract is cash settled. On expiry the purchaser will havemade a profit (or loss) related to the difference between the final settlementprice and the original dealing price. The party delivering the contract will havemade a corresponding loss ( or profit). Remember that futures contracts areeffectively closed out every day by the use of variation margin. Profits and losses arecalculated daily. At expiry, the final day's profit or loss is calculated, variation marginpaid to or received from the clearing house and the initial margin is returned to bothparties. The notional deposit on which the contract is based is not exchangedStock index futuresThe contract provides for a notional transfer of assets underlying a stock indexat a specified price on a specified date.The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 6CT2-05: Use of derivativesCurrency futuresThe contract requires the delivery of a set amount of a given currency on thespecified date1.3 Uses of financial futuresa pany can use financial futures to"lock in"the value of assets or liabilitiesor to guarantee the value of receipts and paymentsThere are many circumstances that can lead a pany to use the financial futuresmarket, some are more obvious than others. Some examples for each of the abovecontract types are listed belowBond futuresWhen issuing bondsIf a pany intends to issue bonds in the future but wishes to lock in the current levelof yields, it could sell some bond futures contracts at the current price, thereby lockingin current yields. This futures position would be unwound when the actual bondFor example, suppose the pany agrees to sell bonds at 110 in 3 months'time(thetime of the proposed issue of the new bonds ) If the price increases to 120, then thepany will lose on the future(it has to sell bonds worth 120 for only 110) but gainfrom the higher issue price of its bonds. On the other hand, if the price falls to 100, thepanys gain on the future will be offset by its lower issue priceWhen it has a fixed-rate loanA pany could agree to buy bond futures contracts to hedge the risk of interest ratesfalling if it has a fixed-interest rate loanIf interest rates fell, bond prices would rise and therefore, it would offset the"loss"frombeing unable to benefit from the fall in interest rates on its loan with a"gain"on itslarly, if interest rates rose, bond pould fall and therefore thpany would gain from its fixed interest rate loan but lose on its bond futuresC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-05: Use of derivativesPage 7Short interest rate futureWhen it has a floating-rate loanA pany could use interest rate futures to protect it from the risk of rising interestrates. For example, if a pany has raised capital by borrowing at floatinginterest rates, but wishes to fix its future interest payments, it can use interestrate futures to fund any increase in the interest rate payable(but will have to payover any interest saved if market rates fall)uppose a pany has to borrow in three months'time and is worried that interestrates will rise from the present rate of 4% pa. It could lock in the current interest rate byselling short interest rate futures. It could agree to sell sufficient contracts at the currentprice of 96 to hedge its borrowing costs in three months timeIf interest rates rose to 6% pa over the next three months, the price of the interest ratefuture would fall to 94. The profit the pany would make on this transaction wouldoffset the higher borrowing costsIf interest rates fell to 2% pa over the next three months, the pany could borrow at alower cost than it expected. However any profit from the lower borrowing costs wouldbe offset by the loss on the interest rate future contractsStock index futuresDuring a takeoverDuring a takeover, a rise in the target panys share price can cause an increase in theamount the predator pany has to pay. We are assuming here that part of the offer isfor cash and that the cash needed to pay for the target pany will increase if the pricegoes up. The predator pany can buy stock market index futures to hedge this riskQQuestion 5.2How would stock index futures help hedge the risk that share prices rise during the bid?Question 5.3What are the limitations with such a hedging strategyThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 8CT2-05: Use of derivativesCurrency futuresIn the same way, currency futures could be used to fix the value of foreignreceipts or payments. In practice, forward currency markets would be usedIt is not difficult to think of situations in which a non-financial pany might usecurrency futures, although currency forwards would be more mon. In the followingexample, we describe a situation in which a pany might use currency futures tohedge a currency risk, and explain the advantage of futures over forwardsTo fix the value of receiptsExampleCompany XYZ is expecting a payment of $100 million at the end of a year and thosedollars must be converted back into the domestic currency(sterling). It might choose tosell the dollars forward, thereby fixing the value of the receipts in the domesticcurrency.Suppose XYZ sells $100 million for E60 million for settlement in one year's time. Thiscan be done either with a bank as a forward contract or through the exchange in the formof futures contracts. The amount of dollars sold is sufficient to hedge the fullanticipated $100 million foreign earningsHowever, the amount of the US dollar payment is subject to review, eg a large part ofthe work is cancelled leading to a reduced payment of only $50 million at the end of theyear. XYZ is now"over-hedged "because it has a contract to sell $100 million at theend of the year but only expects to receive $50 million. It has two optionsIf it bought futures contracts then it can close out half of the contracts it boughtin the market. It will reduce the futures exposure until it has a liability to sellonly $50 million dollars in a years time.If it bought a forward contract then it must settle that contract. XYZ shouldtherefore take out a fresh contract to buy $50 million for f30 million forsettlement in one years time. This contract will cancel out half of the existingedgeIt can be seen that the futures contract gives the pany additional flexibility in thesecIrcumstancesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-05: Use of derivativesPage 9Question 5.4Why might futures contracts be a useful product during pricing negotiations whenvarious panies are presenting bids for a large construction project?The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-05: Use of derivatives2 Options2.1 IntroductionDefinitioAn option gives an investor the right, but not the obligation, to buy or sell aspecified asset on a specified future dateThe buyer of an option has the right but not the obligation to take up the option at thespecified exercise price. The seller (writer )of an option has the obligation to honourthe option given to the buyerMargins and premiumsThe writer of the option pays a margin to the london clearing House. The buyer pays apremium to the writer.Types of optionsA call option gives the right, but not the obligation, to buy a specified asset on aset date in the future for a specified price.A put option gives the right, but not the obligation, to sell a specified asset on aset date in the future for a specified priceAn American style option is an option that can be exercised on any date beforeits expiry.A European style option is an option that can be exercised only at expiry.Traded options are available on individual equities and also on financial futurescontractsWe looked at warrants and executive share options in Chapter 4C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-05: Use of derivativesPage 112.2 Uses of optionsOptions allow a pany to protect itself against adverse movements in thefinancial environment while retaining the ability to profit from favourablemovementsFor example, a pany that has borrowed at variable interest rates couldpurchase options to protect itself against increases in market interest rates. Ifrates fall the pany will only suffer the loss of the premium paid to purchasethe optionsQuestion 5.5What option would be used in these circumstances?Since an option is a right to buy (or sell) an asset rather than an obligation to do so, thepany that holds the option can choose to exercise it or not, depending on whetherevents move in its favour or move against it. Therefore the option never bees aliability to the panyQuestion 5.6Is this a“no-lose” situation for the panyThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 12CT2-05: Use of derivatives3 Interest rate and currency swaps3.1 IntroductionDefinitionA swap is a contract between two parties under which they agree to exchange aseries of payments according to a prearranged formulaThe parties involved in a swap are often called counterpart a eferred to as the marketUsually one party to a swap agreement will be a bank(often remaker)and the other will be a pany. The bank will enter into many such swapsPricingThe swap will be priced so that the present value of the cashflows is slightlynegative for the investor and positive for the issuing organisation Thedifference represents the price that the investor is prepared to pay for theadvantages brought by the swap on the one hand, and the issuers expectedprofit margin on the other.RisksEach counterparty to a swap faces two kinds of risk:Market riskThe risk that market conditions will change so that the present value of the netoutgo under the agreement increasesThe market maker will often attempt to hedge market risk by entering into anoffsetting agreement. In other words the market maker would enter into a secondagreement, which worked in the opposite direction, so that the potential loss is cancelledCredit riskThe risk that the other counterparty will default on its paymentsThis will only occur if the swap has a negative value to the defaulting party sothe risk is not the same as the risk that the counterparty would default on a loanof parable maturityC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-05: Use of derivativesPage 133. 2 Types of swapsInterest rate swapsp in the most mon form of interest rate swap one party agrees to pay to theother a regular series of fixed amounts for a certain term. In exchange, thesecond party agrees to pay a series of variable amounts based on the level of ashort-term interest rate. Both sets of payments are in the same currency.The fixed payments can be thought of as interest payments on a deposit at afixed rate, while the variable payments are the interest on the same deposit at afloating rate. The deposit is purely a notional one; no exchange of principaltakes place.A pany might agree to pay(usually to a bank)6% fixed for 10 years based on anominal amount of f100 million. This would involve making payments of f6 millioneach year for 10 years to the bank. In return the pany would receive interest basedon the 6-month money-market interest rate over the same 10-year period and based onE100 million nominal. The money-market interest rate will be determined by supplyand demand from institutions wishing to lend and borrow for 6 months and willfluctuate on a daily basis. It will also be affected by base rates. The initial interest ratereceived would be linked to the current 6-month interest rates and might be(say)5% paBut this would be re-fixed every 6 months by reference to the interbank market 6-monthdeposit rate. It may be substantially above 6% by the end of the 10-year period, inwhich case the pany would receive substantially more than it has to payQuestion 5.7Why might a pany choose to pay a higher rate and receive a lower rate?3. 3 Currency swapsA currency swap is an agreement to exchange a fixed series of interestpayments and a capital sum in one currency for a fixed series of interespayments and a capital sum in another.A pany might agree to pay the current us dollar fixed rate for 10 years based on anominal amount of s100 million and receive the current UK fixed rate for 10 yearsbased on a nominal amount of t60 million. Note the difference here between singlecurrency interest rate swaps and cross currency swaps(or currency swaps)The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 14CT2-05: Use of derivativesThe nominal amounts used to calculate the interest payments are different in the twocurrencies. Alternatively it could agree to receive UK floating rate interest on the basiof the 6-month UK interest rate, re-fixing every 6 months for 10 years. Both of theabove would be classed as currency swapsOne important aspect of currency swaps is that the nominal amount of each position isexchanged at the end of the contractFor example, at the expiry of the currency swap described above, the party receiving theUS dollar coupons would receive a payment of $100 million, exactly as if he had boughta 10-year US bond. He would simultaneously have to pay an amount of E60 millionexactly as if he had issued a uk sterling bone3.4 Uses of swapsRisk managementA pany can use swaps to reduce risk by matching its assets and liabilitiesFor example a pany which has short-term liabilities linked to floatingnterest rates but long- term fixed rate assets can use interest rates swaps toachieve a more matched positionCurrency swaps would be used by a pany with liabilities in one currencyand assets in anotherCompanies are often involved in large overseas projects, where the project will earnprofits in a foreign currency for 10 years and then be sold at the end of the 10-yeaperiod Such panies might be interested in such a swapQuestion 5.8Why might using swaps be suitable under such conditions?C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-05: Use of derivativesPage 15Reducing the cost of debtIf one pany has a parative advantage in borrowing at a floating ratewhile another pany has a parative advantage in borrowingrate, they can use an interest rate swap to reduce the total cost of financing andboth benefit from a lower cost of debtNote that parative advantage here implies that the panies' relative creditratings are different in the long and short-term debt markets.Swaps enable panies to borrow in the form that offers the lowest yield margin(orfinancial cost) to them. If the cheapest form of borrowing is not what the panywants, it can swap the payments into the desired form(ie floating or fixed) using aninterest rate swap. Similarly, if the cheapest form of borrowing is not in the currencythe pany wants, it can use a currency swap to swap the payments into the desiredcurrencya The emphasis in Subject CT2 is on the practical uses of derivatives. For exampleExplain the possible uses by a non-financial pany of swaps. (September 2002)There are two sorts of swaps to discuss (interest rate swaps and currency swaps )and twomain motives(reducing risk by matching assets and liabilities and reducing cost)The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-05: Use of derivativesThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-05: Use of derivativesPage 17Chapter 5 SummaryDefinitionsA forward contract is a contract to trade an asset at a fixed price at a fixed date in thefuture. A future contract is a standardised, tradable contract to trade an asset at a fixedprice at a fixed date in the future. A financial future contract is based on an underlyingfinancial instrument rather than a physical modityAn option gives an investor the right, but not the obligation, to buy or sell a specifiedasset on a specified future dateA swap is a contract between two parties under which they agree to exchange a series ofpayments according to a prearranged formulaUses of derivativesThe uses of derivatives vary widely and can involvecurrency risk managementinterest rate risk managementborrowing cost reductionCompanies traditionally use forward contracts for delivery of the raw materials requiredfor their business. Forward contracts will normally result in deliveries of raw materialsto the buyer of the contractFutures contracts on the other hand are used to hedge price movements in modityprices or finance costs. These are normally closed before reaching the exercise dateOptions offer panies the ability to hedge downside risk while leaving open thepossibility of upside risk. The cost of this opportunity is the insurance cost of the optionpremiumBoth interest rate and currency swaps are used by panies primarily to manage theirdebt. Companies can reduce risk by structuring their debt to be consistent with theirassets. This can mean swapping fixed into floating rates or vice versa, or indeedswapping a liability in one currency into one in another currency. Swaps can alsoenable panies to reduce the cost of debtThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-05: Use of derivativesThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-05: Use of derivativesPage 19Chapter 5 SolutionsSolution 5. 1The exchange assumes responsibility for the settlement of all contracts. Thus it assumessubstantial credit risk itself, in that if any trader fails to settle, then the exchange mustsettle the deal on their behalf and suffer the loss for this reason the exchange insiststhat traders place sufficient funds in an account to cover:the current negative value of any outstanding contractsan extra amount to cover any likely future volatility in the contract over a shortThe exact rules are very plex, and vary from contract to contractSolution 5.2The pany purchases sufficient stock index futures to hedge the amount of its cashoffer. If the market rises sharply and the pany is forced to raise the amount of itsbid, it should make sufficient profit on its futures contracts to offset this higher costSolution 5.3The share price of the target pany might not move in line with the market indexas is often the case in the mercial world the exact cash movements are seldomknown in advance. The key is to hedge the best estimate of the known risksSolution 5. 4When panies submit bids for construction projects they are exposed to currency andinterest rate movements during the period that the bids are being considered. USingfutures contracts the current market rates can be used to price the bids, and then thepany can hedge its exposure through futures contracts. Even if market rates moveduring the bidding process, the pany can still be confident that its bid is sufficient toundertake the project profitably. Of course if the bid fails, the pany has beenexposed to the markets to the extent of the hedge! The pany might prefer to useoptions on currency futures for this purposeThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-05: Use of derivativesSolution 5. 5The pany would buy a put option on interest rate futures. This would give it theright to sell interest rate futures at a fixed price at a fixed date in the future. If interestrates rise, then the price of the interest rate future would fall, so the pany wouldexercise its option to sell, thus making a gain on the future to offset the higher interestrates it has to pay on its loan. On the other hand, if interest rates fall (and the price ofthe future rises) the pany will not exercise its right to sell, and will just benefit fromthe fall in interest rates on its loanSolution 5.6No. The pany must consider the cost of buying the option, ie paying the premiumSolution 5There could be many reasons which includeThey expect the shorter rate to rise over the period such that at the end of the 10-year period the pany will receive more interest than it is payinThey expect long-term yields to rise in the near future. If long-term rates rise to7%, the contract that the pany owns (to pay 6% and receive 6 month floatingrate) will be worth moneyIt has fixed rate ine and fixed rate finance over the 10-year period. It canreduce this investment risk by making this swapAccording to the expectation theory of the yield curve(considered in detail in SubjectCAl), the total return to the investor from investing for 10 years fixed and fromvesting continuously in 6-month deposits over a ten-year period should be the sameIndeed the 10-year fixed rate is the markets best estimate of the total annual return fromreinvesting continuously in 6-month depositsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-05: Use of derivativesPage 21Solution 5 8If the pany's domestic currency is(for example)dollars, and it expects to receive aflow of euro profits for 10 years, then a currency swap would essentially sell all of theseforeign payments into dollars. Even if the euro payments fluctuate, a swap would go along way to hedge the overall currency risk involvedAt the end of the period the asset will be sold for euros. The exchange of nominal at theend of the currency swap hedges this payment as well(albeit in an approximatemanner)The Actuarial Education CompanyC IFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesPage 1Chapter 6Issue of sharesSyllabus objectives(v) Demonstrate a knowledge and understanding of the characteristics of theprincipal forms of financial instrument issued or used by panies and theways in which they may be issued.Outline the reasons a pany might have for seeking a quotation on theStock exchangeOutline the following methods of obtaining a quotation for securitiesoffer for saleoffer for sale by tendeoffer for subscriptionplacingDescribe the following types of new issues to existing shareholdersScrip issue6. Describe the role of underwriting in the issue of securitiesThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 2CT2-06: Issue of shares0 ntroductionIn Chapters 2 and 4 we introduced the main securities traded in the financial markets. Inthis chapter we look at some aspects of how the markets for these securities actually workWe look at how panies issue securities, and how securities are subsequently tradedThere are two types of transactions to considernew issues (or"primary "market transactions) where a borrower (eg a panyor a government) raises money by selling securities to lenders(eg institutionalinvestors such as pension funds and life offices)secondary market transactions where one investor sells the security on tanother investorSecondary market transactions also serve a useful economic purpose. If shareholderscould not easily sell their shares, few people would be willing to buy shares in the firstaceThe structure of this chapter is as followsSection 1: Obtaining a stock exchange quotationSection 2: Issues made by panies already quotedThe information in this chapter reflects the UK context but similar issues applyin other countriesThis chapter has been quite heavily examined in the past. Examination questions havetested knowledge of the various methods of issuing shares(for panies applying for aquotation and for those panies already quoted which undertake a rights issue or acrip issue); understanding of the implications of a rights issue and a scrip issue; and theability to analyse the strengths and weaknesses of these issues from the point of view ofthe pany and the shareholderC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesPage 31 obtaining a stock exchange quotation1.1 Meaning of the word quotationIf a pany successfully obtains a quotation on a stock exchange, the price ofits securities will be included on the exchange's official list. Such quotedsecurities are called listed securitiesThe uK Stock Exchange runs two different markets for UK equitiestheAlternative Investment Market"(AIM)(established in June 1995)2. the main marketCompanies requiring a quotation on either market must fulfil certain minimumrequirements. The minimum requirements for a"full listing on the Stock Exchangesmain market are more severe than for an alternative Investment market quotation Forexamplea full listing requires 25% of shares to be in public hands( there is no suchrequirement for an AIM quotation)a full listing requires a three-year trading record(there is no minimum tradingrecord required for an AIM quotation)There are over 1, 600 panies with a full listing on the UK Stock Exchange, and over1, 600(generally smaller) panies quoted on the AIM1.2 The reasons for seeking a quotationObtaining a quotation has costs(eg accountants,, solicitors'and brokers'fees)as does maintaining a quotation(eg an annual fee paid to the Stock Exchange)So why do panies choose to incur these costs? possible reasons are set out onthe following pagesTo raise capital for the panyMost businesses start off small and, if they are successful, grow over a period of timeThere may e a stage in the life of a pany where further expansion requires morecapital than the existing shareholders and the panys bankers are willing to provideobtaining a quotation allows the pany to sell new shares to a wide marketand thus raise large sums of money as cheaply as possibleThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 4CT2-06: Issue of sharesThis is often the prime motivation for obtaining a quotation. The vast majority ofpanies choose a method of obtaining a quotation which simultaneouslyraises new fundsTo make it easier for the pany to raise further capitalOnce a pany has a quotation, it will be easier for it to sell new shares in thefuture. In addition, providers of debt finance will be happier to lend money to aquoted pany because they will feel safer in the knowledge that the panyhas to meet the Stock Exchange's on-going quotation requirements (egconcerning the availability of information on the pany)To give existing shareholders an exit routegot to he her mon reason for obtaining a quotation. A family run business may haveThis is anstage where the family members want to retire, or where they feel that thepany would do better with professional managers. Alternatively, the family maysimply want to realise the value of their investment. Whatever the reason, obtaining aquotation provides an easy way for a family to sell its holdings. This will usually formpart of the process of obtaining a quotationSimilarly, specialist providers of equity capital to small unquoted businesses(known as venture capitalists) usually want to realise their investments after afew years. a quotation provides an exit route for venture capital investment(often referred to as"private equity")To make the shares more marketable and easy to valueThe reasons given in the list below are unlikely to be the main motivation for a quotationHowever, the directors may feel that the following advantages for shareholders willreinforce some of the other benefitsThe fact that shares can be easily valued helps with inheritance and CGTtax calculationsBecause the shares are more marketable and more easily valued,shareholders will find the shares more useful as backing for their ownborrowingQuoted panies often use their own shares to offer to the targetpany' s shareholders in a takeover bid. Quoted shares are much moreeffective for this purpose. Note hovevethat obtaining a quotation couldmake the pany more likely to bee the target of a takeover.Some panies offer employee share schemes to help motivate theirstaff. Such schemes will be more attractive if the shares are quotedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesPage 5Question 6.1What is the difference between primary and secondary markets?Question 6.2What is the case for and the case against obtaining a quotation?1.3 Methods of obtaining a quotationWe will now look at the main methods of obtaining a quotation These areoffer for sale at a fixed priceoffer for sale by tenderoffer for sale by subscriptiontroduction1.4 Offer for sale(at a fixed priceDescriptionThe usual method for obtaining a stock exchange quotation and simultaneouslyraising new money is an offer for saleIn an offer for sale at a fixed price, a predetermined number of shares(or othersecurities)is offered to the general public at a specified price via an issuing houseThe shares offered could be new shares (if the purpose of the quotation is for the panyto raise money). Alternatively, the shares may be old shares (if the purpose of thequotation is for the existing sharcholders to sell some or all of their shares)Offers for sale are the most mon method used to obtain a listing. Also, offers for saleare almost exclusively used when a pany first obtains a quotation(ie an offer for saleis hardly ever used on other occasions). Companies that are already quoted are more likelyto use rights issues to raise further equity capital. (See Section 2.)The Actuarial Education CompanC IFE: 2009 ExaminationsPage 6CT2-06: Issue of sharesThe issuing house and underwritingRather than selling shares directly to the public, the pany or existingshareholders sell the shares to an issuing house. The issuing house is thenresponsible for selling shares to the public. In this way the issuing houseunderwrites"the issueIf the public does not buy all of the shares that are offered, the issuing house(and thosewhom the issuing house gets to"sub-underwrite")will end up holding the shares. Thepany (or existing shareholders) are certain to raise the required amount of moneyUnderwriting is covered in more detail later in the courseIssuing houses are usually part of an investment bank. As well as underwritingan offer for sale, their role is to act as professional advisers to the pany,overseeing the whole process and co-ordinating the activities of the otherprofessional advisers. Issuing houses may be remunerated in one of two waysa fee is charged to the pany, or2. the price at which the securities are sold to the issuing house is a little below theprice at which the securities are subsequently sold to the publicIssuing houses are very keen that issues with which they are involved are successfulConsequently, the reputation of the issuing house is sometimes used by investors as anindication that the offer is a good one. This reinforces the issuing houses'desire tomaintain their good nameTimetable for an offer for saleAbout one year before the offerThe directors of a pany wishing to obtain a quotation will usually start to talk to anissuing house at least a year before the securities are offered for sale. The issuing housewill want to satisfy itself that the pany and its directors are suitable beforeThe issuing house will try to ensure that pre-launch ments appearing inpress are favourable. The pany will also need to prepare itself eg bychanging its Memorandum of Association to make it a public limited pany(see Chapter 2). A sponsoring broker will be appointed to discuss the issue with, andget approval from, the Stock Exchanges Quotation CommitteeC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesPage 7The weeks leading up to the issueIn this period the issuing house will advise on the price which should be setSetting a pian be quite difficult. Both the issuing house and the pany will wantto avoid an undersubscribed issue because it is felt that this damages the reputation ofboth. The tradition is to be fairly conservative in pricing new issues- ie set theprice onoversubscribed. the final price will not be set until the formal prospectus ispublishedsuing the prospectus-“ mpact day”Once the offer price is set, the prospectus (or listing particulars)is madeavailable to the public. The prospectus, or alternatively an offer notice, will bereproduced in at least one national newspaper, and the prospectus may be madeavailable through other channels such as high street bankThe prospectus contains a great deal of information about the pany, itsactivities, financial position, reasons for the issue and people involved in theissue. There is a duty on the professional advisers to disclose all relevantinformation, and the issuing house will want to protect its reputation. Therefore,information in a prospectus is generally reliable. The prospectus will also include anTypically, applications from the public to buy securities can be made for a periodut a week following the issue of the prospecUsually, the issue will have been oversubscribed by the time the offer is closedIn these cases the issuing house needs to determine the basis of allocation iehow it will determine which offers to accept in full, which to reject, and which toscale downOften there are two objectives to be balancedensuring that the securities are widely held(so that there is an active market in theshares)2. reducing administration costsa basis of allotment could be to reject all applications for less than, say, 1, 000 shares, tofully meet applications for between 1,000 and 20,000, and for applications over 20,000shares to give only, say, one share for every five applied for. Another monallocation method is to use a ballot in order to determine which applications areaccepteedThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 8CT2-06: Issue of sharesLetters of acceptanceLetters of acceptance are sent out to successful applicants, and refund chequessent to those whose applications were rejected, or were scaled down. It takessome time for share certificates to be issued and in the meantime the letters ofacceptance can be used in place of share certificates for trading. Official tradingon the stock Exchange starts the day after acceptance letters are posted.ConclusionThe need to advertise in a national newspaper and to deal with lots of applications fromthe public, together with the cost of underwriting, make an offer for sale very expensiveHowever, the big advantage is that it ensures the widest possible market for thesecurities. It is the most mon method of obtaining a quotation for large issuesd, the Stock Exchange does not normally allow a quotation involving more thane50m of shares to be made without an offer for sale(at a fixed price or by tender)1.5 Offer for sale by tenderDescriptionD= An offer for sale by tender is similar to an offer for sale at a fixed priceHowever, instead of inviting applications at a specified price, the issuing houseinvites members of the public to submit a tender stating the number of shareswhich they are prepared to buy, and the price which they are prepared to pay.The prospectus will give a minimum price, but it is up to investors to determine howmuch to bidAfter the offer closes, the issuing house will determine a single strike priceThis may be the highest price at which all the stock can be allocated. However,a lower strike price will be chosen if this is necessary to ensure a sufficientspread of shareholders. All applicants who bid at least as much as the strikeprice will have their applications acceptedAll successful applicants will pay the strike price, regardless of how much morethey had bid. Applicants who bid less than the strike price will have theirapplications rejectedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesPage 9ConclusionA pany can raise more capital through using a tender rather than a fixed price,because investors are asked, in effect, to state the maximum amount that they areprepared to pay for the sharesHowever, the allocation process for an offer for sale by tender is more plex. Themethod is also more likely to produce a more concentrated ownership of the shareswhich is detrimental to their marketability. This is not only because smaller investorsare put-off by the tender process, but also because all investors who bid below the strikeprice in the event of the offer being over-subscribed receive no shares at all. Thiscontrasts with an offer for sale at a fixed price. Here, if the offer is oversubscribedapplications will often be scaled down. In fact, sometimes the strike price of an offerfor sale by tender may be reduced and applications above the strike price scaled downso as to achieve a wider share ownership1.6 Concessionary methods of obtaining a listingThe Stock Exchange likes offers for sale because it ensures a wide ownership ofsecurities and because all investors are treated equally. However, in somecircumstances the Stock Exchange allows alternative new issue methods to be usedOffer for subscriptionThese are similar to offers for sale. They are normally at a fixed price, but canbe by tender However, the whole issue is not underwritten the pany sellshares directly to the public. The issuing pany bears(at least part of)therisk of undersubscription. An issuing house will still be employed as an adviserto the issueSometimes offers for subscription are used for unusual issues (eg a hi-tech bio-researchpany)and launches of investment trusts. In these types of issue it is far from certainwhether investors will want to buy shares, and how many can be sold. In these cases theoffer for subscription will only go ahead if a minimum number of shares are purchasedIf too few applications are received, all applications will be rejected and chequesreturned. If an offer for subscription is used, only new shares can be soldP In an offer for subscription the issuing pany sells its securities directly to the public,and bears the risk of undersubscriptionThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-06: Issue of sharesPlacings(or"selective marketings")Raising money from the public can be an expensive exercise. A simpler, cheapermethod of making small issues is known as a“ placing”or“ selectivemarketingThe issuing house first buys the securities from the pany. The issuing houseor a stockbroking firm, will then individually approach institutional investors suchas pension funds and life offices directly. The institutions will be offeredsecurities, but no public applications are invitedSmaller investors dislike placings because they are not able to buy the shares. Theywould have to buy the shares later from one of the lucky institutions, usually at a pricein excess of the placing priceCompanies like placings because they are cheaper for two main reasonsadvertising and administration costs are minimisedno sub-underwriting is needed(the process of a placing itself is very similar tothe process used to obtain sub-underwriters anyway)In a placing the issuing house offers securities to a small number of its institutionalclientsIntroductionsNot all of the reasons for wanting a stock exchange listing involve the immediate desireto raise new money or the sale of existing shares. In these cases, a stock exchange mayallow the shares to be "introduced ""to a stock exchange listinIntroductions do not involve the sale of any shares. They simply mean that theexisting shares will in future be quoted on the London Stock ExchangeAs always for a full listing, 25% of shares must be in public hands, that is, thefree float'of shares available for purchase excluding strategic holdings insubsidiaries or cross-holdings must be at least 25% of the issued shares. theStock Exchange only allows introductions in cases where this requirement isalready met.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesIntroductions can be used in several circumstances. For examplewhere an overseas pany is already listed in, say, the USA, but wants to havea uk Stock Exchange listing as wellwhere an already listed pany wants to"de-merge"into two or more separatepanies; the new panies will obtain a quotation by way of an introductionwhere an unquoted pany already has shares in wide ownership and sufficientcapital but wants to bee quoted1.7 The role of underwritingIn a previous section we mentioned underwriting in the context of an offer for saleUnderwriting is always used for an offer for sale. Underwriting may also beused for other share issues. The procesa pany wants to raise equity capital by issuing shares. Rather than run therisk of not managing to sell all the shares and raise enough money, thepany arranges to sell all the shares at an agreed price to the issuinghouse. The pany will pay the issuing house a fee. Alternatively, inthe case of an offer for sale the fee can be included in the differencebetween the price at which the shares are sold to the issuing house andthe price at which the issuing house sells them to the publicderwriting is really like insurance for the pany against the risk that theIssue may notThe issuing house accepts the risk that all the shares may not be boughtHowever, the issuing house will not want to retain the entire risk. Theissuing house will arrange sub-underwriting. In return for a missionthe sub-underwriters agree to take a proportion of the shares that are notbought by the public. Usually the issuing house will use several institutionainvestors such as pension funds and life assurance panies as subunderwriters3Issues are priced so that they should be successful. Issuing houses takecare not to over-price issues. The main risk faced by underwriters is thatan unexpected event occurs between agreeing to accept the underwritingand the closing date for the offer for sale. For example the stock marketcrash in October 1987 occurred just as the governments offer for sale in BPshares was taking place, with the result that the offer was under-subscribed. Thelevel of underwriting risk varies with the time between agreeing to accept theunderwriting and the closing date for the offer for saleThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 12CT2-06: Issue of shares4a. Fully subscribed issue: the issue goes ahead, and is fully subscribedThe issuing house and the sub-underwriters will have madeunderwriting profit equal to their underwriting mission lessadministrative expenses.Partly subscribed issue: the issue goes ahead, but not all of the sharesare purchased. The underwriters and sub-underwriters get theirfee/mission, but they also need to pay for all the shares that have notbeen purchased. Suppose an individual institution had underwritten(as a subunderwriter)y% of the issue. Following an unsuccessful issue in which therewere only applications to buy x% of the entire issue, the institution would beobliged to buy y (100-x)% of the shares at the agreed price. The institution canthen choose to sell in the market at a price that will almost certainly be wellbelow what they have just paid. Alternatively, it can hold the shares on a longerterm basis, and hope that the price will recoverED: Underwriting is a form of insurance against the risk of an unsuccessful issue.Itis used to ensure that the issuing pany raises the required amount of moneyQuestion 6.3What are the main methods by which a pany can obtain a listing on the StockExchange?C IFE: 2009 ExaminationsThe Actuarial Education CompanyPage 14CT2-06: Issue of shares2 Issues made by panies already quoted2.1 IntroductionWe now look at how new shares are issued by panies that are already quoted. Thechoices are set out belowCompany wanting to raise new ordinary share capitalThe UK Stock Exchanges rules require that, in normal circumstances, a panyissuing equity capital or convertibles for cash must offer these issues in the first place tothe existing shareholders in proportion to their holdings. These are called"pre-emptivrights".(This requirement does not cover the case where a pany takes over anotherpany by issuing more shares to the target panys shareholders in return for theirshares. So a quoted pany must make what is known as a"rights issue"to existingshareholders if it wants to raise new equity capitalIn some countries existing sharcholders do not have these pre-emptive rights. Shareholdersmay also vote to waive their pre-emptive rights. In such cases, a pany may use aplacing to raise additional capital as described in section 1.6Company wanting to increase the number of shares in issue, withoutralsing new moneyThis might seem like a strange thing to do, but it happens a lot in the UK. What happensis that new shares are issued to existing shareholders in proportion to their existingshareholdings. No money is raised, no one really gains, and no one really loses. Thistrange exercise is known as a scrip"issue, and is described in this chapter. Manyoverseas countries'investment markets, understandably, view this as a silly thing to doAs we will see, the reasons for having a scrip issue are mainly psychologicalCompany wanting to raise new loan(or preference share) capitalHere the choice is wider. Most panies will use a placing, although an offer for sale orfor subscription could be usedExisting shareholders wanting to sell a large block of sharesOccasionally, a large shareholder will want to sell shares in a quoted pany. In thiscase an offer for sale will normally be made, rather than simply trying to sell a largenumber of shares in the normal way on the marketC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of shares2.2 Rights issuesIntroductionUnder stock Exchange requirements, when panies want to raise morecapital through a further issue of shares, they are obliged to offer the newshares to the existing shareholders. This forms part of the rights of ashareholderA rights issue is where a pany offers further shares, at a given price, toexisting shareholders in proportion to their existing holdingsFor example, a one-for-five rights issue allows each shareholder to purchase one newshare for every five currently heldThe price will be at a discount to the current share price. Otherwise why shoranyone want to buy the extra shares? It would be cheaper to buy further shares in theopen marketThe main effects of a successful rights issue arenew shares are creatednew money is raised for the panythe total value of the whole pany should be increased by the extranoney raisedthe price per share will fall depending on the extent of the discount andthe number of new shares issuedThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-06: Issue of sharesPurpose of a rights issueFrom the pany's perspective there is a very clear objective which is to raisemore money. The reasons for needing more money vary greatly1. the pany has a fundamental problem, and its future survival depends on raisingmore cashto reduce the ratio of debt to equity capitalthe pany has expanded too quickly and needs more cash for day to day needsto finance an expansionary investment programmeto pay for the purchase of another panThe reaction of the stock market to individual rights issues will depend verymuch on the reasons for the issueTimetable for a rights issueA few weeks before the rights issue, the pany will discuss the possibility ofan issue with its advisers. Companies often like to have a rights issue when thestock market is high because they see this as raising more money for a givencost(where cost to the pany is measured in terms of dividends payable)The pany will publish a rights offer document which will explain why therights issue is being made. shareholders are then sent provisional allotmentletters and the shares start to trade ex-rights ie if someone new buys the shares, it isthe seller not the new holder who has the rights. The rights themselves can also betradedShareholders will be given three or more weeks in which to accept the offer or tosell their nil-paid rights, ie rights for which the shareholder has not paid anythingC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesPage 17Impact on share priceBefore looking at the impact on the share price we need the following definitionMarket capitalisation is defined asmarket capitalisation Px number of shareswhere P is the share priceHence before a rights issue, the share price is given byP=market capitalisationnumber of sharesThe price per share after a rights issue isP'=original market capitalisation extra valuetotal new number of sharesTo estimate the ex-rights share price it is necessary to estimate the extra valueponent in the above equation The factors incorporated within the extravalue arethe amount of new money raised by the rights issuethe expenses of the issue+1-the change in value based on the market's revised perception of thepany and the use to which the money is being putignoring expenses and ignoring the market's reactionWhen only the first of the three factors given above is considered when trying tecalculate the price of the shares following the rights issue, this is known ascalculating the theoretical ex-rights priceSuppose a pany with share price P and N shares in issue makes a n-for-m rightsissue at a price of @(at a discount to P)The Actuarial Education CompanC IFE: 2009 ExaminationsCT2-06: Issue of sharesIf we suppose that the extra value to the pany is exactly equal to the gross amountraised, the new share price will be given by:(N×P)+|"N×Qm+nNP+nQm+nThis theoretical price is the weighted average of p, the share price before therights issue, and Q, the price at which the new shares are offered in the rightsissue. Because the new shares are offered at a discount, the ex-rights shareprice will be below the original share priceAllowing for expenses and market reactionsAlthough the expenses item is easy to incorporate into the calculation, it ismpossible to calculate explicitly the market's reaction. Often the share pricemmediately following the rights issue will be depressed below the theoreticalweighted average price becauseshareholders dont usually like being asked for more money, so the panyloses favour with investorsif the rights issue is because the pany is in trouble, market support for thpany fallsthere will be an increased supply of shares in the pany on the market(because some shareholders will sell their rights or extra shares), and this willdepress the share price, in the short term at leastC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesQuestion 6.5Estimate the theoretical ex-rights share price in each of the following casesCurrent price250150p1-for -1Current price250Offer priceCurrent piprice.Issues where lots of new shares are issued (eg number I in the previous question)areknown as"heavy"issues. Issues where only a few shares are issued (eg number 3 in theprevious question)are known as"light " issuesImpact on balance sheetWe will study the balance sheet in detail in Chapter 8. At this stage, you needremember that the share capital shown in the accounts is the nominal value of the issuedshare capital (number of shares x par value of the share). If the pany raises morethan this because the shares are sold above their par value this is shown in the sharepremium account, which is part of the panys reservesFor example, if a pany raises an additional f70m from a rights issue of 100 millionshares of par value 25p, then the issued share capital would increase by t25m and theshare premium account in the reserves would increase by #45mThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 20CT2-06: Issue of sharesQuestion 6.6Describe the impact on the balance sheet of the pany making the first rights issue inthe previous question. Assume that the cash raised from the issue will be held in cash(which appears in current assets in the balance sheet). Before the rights issue, itsbalance sheet appeared as followsCurrent assets350Reserves25p ordinary shares150350Possible courses of action for shareholdersThere mayeveral reasons why a shareholder chooses not to accept therights, such as not having available cash, or not wanting to increase theirexposure in that pany, or not wanting to throw good money after bad (in the caseof an ailing pany)In these cases, shareholders can sell their rights. What they would sell is theirnil-paid right. The theoretical market value of the nil- paid right is the differencebetween the ex-rights share price and the rights issue price. This shouldpensate the shareholder for the loss of value in the original holdingTerminology recapLet us assume a pany's shares are trading at a price of 100p before the panyannounces a rights issue. Immediately after a pany has made an announcement thatit intends to have a( say) I for I rights issue at a subscription price of 50p, we can thinkof an"old"share as being equal to a"new share plus the right to subscribe for anothernew share at the subscription price of 50p. The right to buy a new share is called a"nilpaid"right and can be sold independently of the share itself.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesPage 21The theoretical price of the new shares after the issue is1×100+1×50P75p can be thought of as the value of the""share- ie the value of a share in thpany after the rights issue has been pleted. This is referred to as the"ex-rightsprice"of the share. The value of the nil-paid right is thereforeex-rights price-r'ights issue price= 75p-50p= 25pand these nil- paid rights can be sold separatelyThe holder of a share prior to the issue therefore still holds shares with a value of 100p,prising of a new share(now worth the ex-rights price of 75p)and the nil-paid rig(worth 25p). Immediately after the rights announcement the shares are normally tradedas a bundle of a new share plus the nil-paid right (ie they are not stripped and soldseparately). The market price of this bundle is known as the cum-rights" share priceThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-06: Issue of sharesExamplePrior to a rights issue, shares in Growkwik plc were 100p. New shares were offered ona l-for-1 basis at 50p. The ex-rights price was 75p(ie the theoretical priceShareholder l(has lots of spare cash and likes Growhwik)Original holding of 1,000 shares had market value of fl, 000Shareholder takes up the rights, so spends f500 buying another 1,000 sharesMarket value of 2,000 shares at 75p is f1, 500Increase in market value of holding=amount spentShareholder 2 ( has little spare cash but wants to maintain value of holding in Growkwikat t750Original holding of 750 shares had market value of f750Sells 500 nil-paid rights(out of total of 750 nil paid) at 25p each, raising f125Uses f125 to buy 250 of the new shares at 50p eachMarket value of 1,000 shares at 75p is f750No net expenditure and no change in the value of the holding in growkwikShareholder 3 (keen to reduce holding in Growkwik)Original holding of 10,000 shares had market value of f10, 000Sells all 10,000 nil paid rights at 25p each, raising f2, 500 cashMarket value of 10,000 shares shareholder 3 is left with at 75p is f7, 500Decrease in market value of holding= amount raised through selling rightsNote(1) To do this Shareholder 2 will need to increase the number of shares he owns as the price of his existing shares has fallenfrom 100p to 75pThe example shows that, in theory, a shareholder should be indifferent to a rights issue,whether or not the shareholder is able to take up the rights. The result holds regardlessof the size of the discountThese examples ignore any adverse movement in the share price that may occur throughany adverse market sentiment and increased supply of shares on the market(caused, forexample, by the actions of Shareholders 2 and 3)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesAre rights issues always at a discount to the market price?Yes, unless something goes wrongWhen the issue is announced, the price must be at a discount or else no shareholderswould take up their rights. However, in exceptional circumstances, there may be acollapse in the share price between the announcement date and the pletion of theissue, such that the offer price is no longer at a discount to the market priceUnderwriting of rights issuesRights issues don' t have to be underwritten, particularly if the new shares areoffered at a large discount. However most rights issues are underwritten andthe discount set at about 10% to 20% of the current share priceAs with an offer for sale, having an issue underwritten means that various institutionsagree to buy all the shares that are not taken up in the market. The risk for theunderwriters is that the issue is a flop, and they are obliged to buy millions of shares,possibly at a level above their market value. In return for accepting this risk, theunderwriters will receive a fee of the order of 1% of the money to be raisedIs underwriting needed?The advantage to the issuing pany of having an issue underwritten is that itis certain to raise the desired amount of extra money.However, panies could avoid the need to have an issue underwritten bysetting an offer price that is very low pared to the market price This is calleda deep discount,. In this case, unless there was a total disaster all the rights would betaken up either by shareholders or by other investors who purchase the nil-paid rightsfrom the shareholdersIn order to raise as much money as a less discounted rights issue could raise, a deepdiscount rights issue needs to be"heavier", but this poses no real problems. In the past,Barclays Bank and Prudential have both used deeply discounted rights issues to avoidthe need for underwritingThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 24CT2-06: Issue of sharesThe only problems with deep discount issues areselling rights can count as a disposal for capital gains tax purposes. The biggerthe discount, the higher the price of the nil-paid rights. A deep discount issucan increase CGT liabilities for those investors who choose to sell their rightsompanies are not allowed to issue shares below their par value. This places anupper bound on the size of the discountdeep discount issues are sometimes used by panies who were unable to getunderwriters to accept the risk. Therefore, a deep discount issue can beinterpreted by investors as a sign of weaknessWhat happens if a shareholder does nothing following a rightsissue?The Stock Exchange usually insists that panies sell shares in respect of all the rightswhich were not exercised on behalf of shareholders and then share out the benefit of thepremium over the rights subscription price amongst those investors who didnt exercisetheir rights2.3 Scrip issuesIntroductionTo the logical student actuary, scrip issues(also known as"bonus"or"capitalisationissues)will appear rather bizarreA scrip issue(sometimes called a"capitalisation"or"bonus"issue)is where thepany gives free shares to all ordinary shareholders in proportion to theirexisting holding No payment is required from the shareholdersFor example, a 1-for-2 scrip issue means that for every two shares held, investors are givenThe basic impact of a scrip issue should benew shares are createdno money is raisedthe fundamental value of the whole pany is unchangedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesthe price per share should fall in proportion to the increase in the numberof sharesthe total value of each investors holding should be unchangedShareholders' reserves in the balance sheet are converted to shareCapital(hence the name capitalisation issue). Retained earnings fall andshare capital increasesScrip issues are essentially just a book-keeping exerciseExampleThe balance sheet for Loadsashares plc just before a scrip issue is(in E000s245Debenture150Share capital(25p500eserves976The current price per share is t1. 56. As there are two million shares in issue, the marketcapitalisation of the pany is f3 12mThe directors of loadsashares decide to have a 1-for-2 scrip issue. Each shareholdergets one new share for each two held. This will have the following effectmarket capitalisation should stay at f3 12m(there's no new value)there will be three million sharesthe price per share will be£l.04(e2/3×£156)an investor who held two shares at f1. 56 each now has three at t1. 04 eachsome of the balance sheet reserves will have been capitalisedThe new balance sheet, ignoring the expenses of the issue, will beNon-current assets1,381Current assetsDebenture150Share capital (25p)750ReservesThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-06: Issue of sharesEffectively, a scrip issue is a bit like a rights issue at Op. This is where you should bet's the point of a scrip issue? " This is a perfectly reasonable question. Scripissues dont appear to achieve very much. This is because they don ' t achieve very much!Purpose of scrip issuesThe arguments to support scrip issues are largely psychologicalMarketabilityy having more, lower priced shares, the marketability is supposed to beimproved. In fact, unless the price per share had got very big(over f1,000, say), it's hardto see that this argument is really relevant. Even for the very smallest share transactionsinvestors should be indifferent between 25 520 shares and 250 E2 shares. Howeverapparently UK investors prefer share prices in the range 50p to flO. There might be somemysterious psychological factor for UK shareholders so that they think that ten t2 sharesare better value than one i20 shareSomething for nothinShareholders might like the idea of being given extra shares free of charge(andthat this factor outweighs the fact that each share should drop in value proportionately!Hence the name bonus issuePast profitabilityFrom the example on the previous page, you will see that the scrip issue has convertedsome of the reserves into share capital (ie some of the reserves have been"capitalised")Scrip issues can take place only if there are sufficient reserves to be capitalisedThis means that scrip issues tend to be associated with successful panieswhich have built up large reserves from retained profits. Also, the marketabilityargument that a share price is getting too high(also described as too"heavy")will applyonly to shares that have been successful and risen in priceTherefore, scrip issues tend to be associated with successful panies, so this providesa further positive psychological factor. Success implies that scrip issues arepossible, so scrip issues are taken to imply successC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesPage 27Future confidenceThe minimum price at which a rights issue can occur is the par value of theYet rights issues must occur at a discount. Thereforts issue isonly possible if the current share price is above the par value of the sharesA scrip issue reduces the price of a share. Therefore, having a scrip issue mayreduce a pany,'s ability to have a future rights issue if its share pricedeclined following the scrip issue. So, if the directors decide to have a sciissue, they must be confident about the pany,'s future prospects. Investorswho read this contorted logic into a scrip issue may view a scrip issue as a sign of goodnsed dividendsSome panies have a habit of having light scrip issues(eg 1 for 10)andsubsequently keeping the same dividend per share. In these cases, a scripa sign of, higher dividends. In otherproportion of profits will be paid out as dividends. If shareholders think that they canuse the dividends more profitably than the pany can this is another "good newsaspect of a scrip dividendMore reasonable rate of dividendThis argument depends upon panies not maintaining dividends per shareIf dividends are expressed as a percentage of the nominal value the figure mayseem excessive. This could cause public relations problems, or problems withemployees who feel that dividends are too high. this could be avoided by ascrip issueTrustee statusIt is a requirement of the Companies Act 1985 that a pany must have aminimum issued share capital of Elm before it can act as a trustee. A scripissue converts reserves into share capital, so may allow a pany to meet thisrequirement. The problem here is not one of investor psychology, but of the way inwhich the law was writtenThe downsideIn the author's opinion, the arguments against scrip issues seem to have a little moresubstance than the arguments in favourThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-06: Issue of sharesCost to the panyThe administrative costs such as issuing new shares and informingshareholders are met by the pany. Many of the shareholders would have beenable to suggest alternative uses for the thousands, or perhaps millions, of pounds usedCost to everyone elseWhenever records of dividends or share prices are needed for example forinvestment research or cgt calculations care is needed to eliminate theartificial effect of a scrip issue. Note that the Inland revenue is not so stupid as toallow the reduction in share price caused by a scrip issue to reduce a taxable gain!Impact on share priceOn theoretical grounds, an n-for-m scrip issue should reduce the share pricefrom p tem+nThis assumes that the market is totally indifferent to the scrip issue. the actualchange in the share price might move slightly one way or the other:up slightly if the psychological factors win through, ordown slightly if the market decides that the cost of the issue outweighsthe benefitsIn both cases, the word slightly should be emphasised. In any event, other events thatmay coincidentally occur on the day that the scrip issue takes place might cause moresignificant share price movements than either of these two adjustment factorsIn the long term the share price following a scrip issue might move up more quicklythan the rest of the equity market. Some research seems to support this view. However,this is probably not because of the scrip issue. It is more probably based on the linkbetween successful panies and scrip issues, and the fact that successful paniestend to carry on being successfulC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesQuestion 6.7Calculate the theoretical share price after each of the following scrip issuesCurrent price250Basis1-for-12. Current price250Basis1-for-33. Current price50Basis.1-for-10What is a scrip dividend?A scrip dividend means that a pany pays shareholders a dividend by giving themnew shares rather than cashThere are two cases.everyone has to accept the scrip divieThis is just like a scrip issue(panies use scrip dividends of this type when they can' t afford to pay adividend but don' t want to admit it! ) You will end up with more shares worthless eachthere is a choice between a scrip dividend and a cash dividend: Unlike a scripissue, the scrip dividend option is worth as muchcash dividend. ThoseIvestors that accept the scrip dividend have more shares, but the market valueof the shares will not have been forced down. They have gained as much as ifthey had taken the cash. Really it is like a normal dividend being paid followedby a rights issueWe will study scrip dividends in more detail in Chapter 16Question 6.8Give reasons why a pany would want to have(1 a rights issue(ii) a scrip issueThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 30CT2-06: Issue of sharesQuestion 6.9What do you think happens to the features of a futures or options contract if there is arights issue or a scrip issue?In the past, examination questions on rights and scrip issues have been a mixture ofcalculation questions(eg effect on the share price, shareholder or the balance sheet )anddiscussion questions(eg factors to consider when embarking on a rights or scrip issue;stages involved, advantages and disadvantages)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesPage 31End of part 1You have now pleted Part I of the Subject CT2 NotesReviewor maybe re-read the summaries at the end of Chapters 1 t0 ewBefore looking at the Question and Answer Bank we remend that you briefly revithe key areas of Part IQuestion and Answer bankYou should now be able to answer the questions in Part 1 of the Question and AnsweBank. We remend that you work through several of these questions now and savethe remainder for use as part of your revisionAssignmentsOn pleting this part, you should be able to attempt the questions in Assignment XIReminderIf you have not yet booked a tutorial, then maybe now is the time to do soThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 32CT2-06: Issue of sharesThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesChapter 6 Summaryobtaining a stock exchange quotationA pany may decide to obtain a quotation on the Stock Exchangein order to raise extra capitalto make it easier for future issues of capitalto provide an exit route for its existing shareholdersto make its shares more easily valued and marketable.Many new quotations and issues are dealt with by an offer for sale. This may be at afixed price, or by tender. In an offer for sale by tender, the shares are allocated at astrike price, which is paid by all the successful applicants, no matter how much morethey had bid. Issues are underwritten by an issuing houseIssues can also be arranged by an offer for subscription or by a placing. If the panydoes not need to raise any new finance, it may opt for an introduction to a stockexchange listingIssues made by panies already quotedCompanies can raise more money from their existing shareholders by offering them arights issue. A rights issue reduces the share price and increases both the share capitaland reserves of the pany.A pany can use a scrip issue to increase the number of shares in issue withoutraising any extra finance. A scrip issue reduces the share price, and, whilst keeping thetotal share capital and reserves unchanged, it increases the share capital and reduces thereservesThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-06: Issue of sharesThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesChapter 6 SolutionsPrimary markets provide for the initial raising of funds through the issue of securitiesSecondary markets provide for dealing in securities once they are issuedSolution 6.2Reasons for seeking a stock exchange listingTo raise capital for the paTo make it easier for the pany to raise further capitalTo give existing shareholders an"exit routeTo make the pany 's shares more easily valued and marketablePossible disadvantagesIt is expensive and time- consumingOriginal owners have no control over the future owners of the panya takeover bid is possibleSolution 6.3The main methods areoffer for sale at a fixed price2. offer for sale by tenderoffer for subscriptionntroductionThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-06: Issue of sharesSolution 6. 4(1i) A(ii C(iv) C(v) D(vii) D(viii) CSolution 6.5In each case, we equate what the investor starts out with(ie m shares worth 250p plussome money) to what they end up with(ie m+n shares worth the new price)Let the theoretical ex-rights share price be P2P250+150250×3+15090022511P250×10+150C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-06: Issue of sharesPage 37Solution 6. 6WorkingCurrent number of 25p shares=600mNumber of new shares issued =600mNominal value of new shares =f150mCash raisedf900mExpenses involved in rights issue unspecifiedEffectCurrent assets increase by E900m less expensesOrdinary share capital increases by t150mReserves(ie share premium account) increases by f750m less expensesIf we ignore expenses, the new balance sheet will look like thisNon-current assets250Current assets000Res95025p ordinary shares1250Solution 6.7Again we equate what the investor starts out with(ie m shares worth 250p each) to whatinvestors end up with(ie m+n shares worth the new price)Let the theoretical share price be P2P1254P250×33.11P250×10The Actuarial Education CompanC IFE: 2009 ExaminationsCT2-06: Issue of sharesSolution 6.8(1 A pany would have a rights issue in order to raise some extra capital. Theeasons for needing this extra money might includethe pany needs more cash in order to surviveIty gearingyto finance a programme of expansionto buy another pany(1i) A scrip issue will not raise any more money for the pany, and will not alter thefundamental value of the pany. The reasons for a scrip issue are largelymarketability may be improved by having more shares priced at a lowerpricehareholders may like to be given extra shares free of chargescrip issues provide a way of capitalising past profits and so areassociated with successful paniesa scrip issue may reduce the scope for the directors to declare a rightsissue, so can indicate that the directors are confident about the pany'sdividends: if dividends per share stay the same, then shareholders willfeel good about getting extra money. If they fall in proportion to the scripissue. they may seem to be at a more reasonable ratea pany may wish to increase its issued share capital in order to gaintrustee statusSolution 6.9As far as possible, the derivatives exchange will try to eliminate the impact of thesechanges on people with a derivative position. For example, following a 1-for-l scripissue, the exercise price of a traded option would be halved, and the position of eachoption holder (ie the number of shares the option holder has the option to buy or sell)would be doubledC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsPage 1Chapter 7Introduction to accountsSyllabus objectives(viii) Describe the basic construction of accounts of different types and the role andprincipal features of the accounts of a panyExplain why panies are required to produce annual reports and accounts2. Explain the fundamental accounting concepts which should be adopted in thedrawing up of pany accounts0 ntroductionThis is your introduction to the accounting part of the course. In Part 2 of the course,we introduce the main accounts(the balance sheet, the ine statement, the cashflowstatement and the statement of changes in equity), and learn how to generate theaccounts from the trial balance. In Part 3 of the course, we learn how to analyseaccounts to assess the performance of a panyIn this introductory chapter, we consider the need for accounts, the regulation ofaccounts, accounting standards, the auditors'report and accounting conceptsThe examination is likely to test your knowledge of accounting standards and keydefinitions and your understanding of the need for accounting information, the keyaccounting concepts and the subjectivity inherent in accountsThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 2CT2-07: Introduction to accounts1 The accounting frameworkEach year a pany will publish four main types of accounting statement1. an ine statement(showing the ine, expenses and hence shareholdersprofits for the year)a balance sheet(showing the assets, liabilities and shareholders' funds at the endhe year)3. a cashflow statement to show where the cash has e from and how it has been4. a statement of changes in equity to show how the position of equity haschanged over the yearWe look at each of these accounts in Chapter 8Companies are required to produce a set of annual reports and accounts in an attempt tofulfil the needs of the various users of accounting information1.1 UsersIt has been suggested that financial statements have four groups of usersequity investors(ie both actual and potential shareholders)an creditors( both long-term and short-term)employeesbusiness contacts(ie customers and suppliers)The accounts have many other uses, and will be used bya stock exchange to ensure that certain requirements are metthe management themselves as a source of informationthe tax authorities as a starting point in the calculation of the tax liabilitystock analysts as a source of financial informationredit rating agencies in order to assess the creditworthiness of the panyC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsPage 3The members of each of these groups has a legitimate interest in the financialstatements as followsequitInvestment decisions require information about profitinvestorsand cashflows. Analysts are constantly preparing andupdating forecasts of performance. The annual reportprovides an opportunity to " fine tune"these forecastsExisting shareholders also require information about thetransactions authorised by the directors for stewardshippurposesloan creditors Lending decisions involve the measurement of the risk ofdefault. a lender wants to know whether a business cangenerate sufficient cash to repay any loan. the lender willalso wish to ensure that the business has an adequateasset base to meet its obligations in the event of failureTo this end, loan agreements often contain restrictivecovenants which are based on accounting numbersCovenants specify a value for a summary statistic, such asgearing ratio(which measures debt as a proportion of long-termemployeesEmployees are interested in the enterprise's ability to paysalaries and also to offer job security. Accountingformation is, however of limited value for suchThe cashflow statement will be useful. as will indicators ofprofitabilitybusinessBusiness contacts are interested in continuity of sales(tocontactscustomers)and of materials and services (from thesuppliers). Their interest is, therefore, similar to that othe shareholdersy may also use aginformation to try to gain some insight into the pany 'spricing and trading policiesQuestion 7. 1Why might the holder of a loan stock issued by a pany wish to have a restrictivecovenant based on some accounting ratios?The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 4CT2-07: Introduction to accountsThe annual report of a large pany will, therefore, have a wide readership Inaddition to the " legitimate"users described above the financial statements willalso be read bgovernment agencies(including the tax authoritiespetitorspotential predators.The relationship between the management of a pany and the various userslisted above can be plex. At best there is likely to be a degree of mistrust.For example, shareholders might be concerned that the directors will act in theirown best interests even when this would be to the detriment of the pany.Examplea director who has various share options maturing in 6 months'time is faced with adecision on whether or not to make a provision for a debt owed to the pany thatseems unlikely to be repaid. If he provides for it, this year's profit will be below theprevious year's and the share price will fall. If he chooses to wait until the interim profistatement before announcing the provision, the profit will be above that expected forthis year and the share price will rise (until the announcement! and allow him toexercise his share options. In such a situation the director might be inclined to take arosier view of a potential liability, and decide not to make a provision in the accountsfor a potential lossThe above example is rather extreme! In practice, a single director will not determineaccounting policies. Independent non-executive directors are in place to prevent orreduce the possibility of something like this happening. Nevertheless, suspicion doesexistAt worst there will be outright hostility. For example, the directors are unlikelyto volunteer information about the pany's performance if that could be usedby a potential petitor. Management might, therefore, be tempted to withholdnformation or to distort any figures which they do publishC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsPage 51.2 Sources of regulationThe credibility of published financial statements is protected by the impositionof regulations from a diverse range of sourcesThe diagram below(which is part of Core Reading) illustrates the breadth of thebody of regulation that affects a limited pany which is listed on a stockexchange. a detailed knowledge of these rules is beyond the scope of this syllabusInternational AccountingPrinciplesNational panyStandardsconcepts andlawsconventionsaccountsGood practice bOther legislationeadingStock exchangepaniesrequirementsBroadly, the rules can be broken down into those which require specificaccounting treatment or disclosures, because of national laws or a stockexchange's listing rules, and those which deal with the manner in which thesenumbers could be calculated mainly the professional accounting standardsand the concepts and conventionsFor example, in the UK, the Companies Act 1985 requires that panies shouldstate the amount charged for depreciation, but the rules concerning thecalculation of depreciation are to be found in International AccountingStandard 16 Property, plant and equipmentThe fact that there is such a network of sources of regulations and regulatorsan make the preparation of financial statements a rather plicatedundertaking. Fortunately, there is a reasonable amount of articulation betweenthe various rulebooksThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 6CT2-07: Introduction to accounts1.3 Statutory requirementsIn many countries, national legislation may be in place to dictate what kind offormation should be published in financial statements For example, in theUK, the Companies Act requires a number of documentsThe Companies Act explicitly requires panies to producea balance sheet showing the financial position on the last day of thepany's financial yearan ine statement for the financial yeardetailed disclosures which are normally presented as a series of notes tothe accountsa directors’ reportan auditors’ reportQuestion 7.2What is the purpose of requiring that the accounts of every pany should be inspectedand signed off by a professional accountancy firm?The form and content of the ine statement and the balance sheet wil bediscussed in Chapter 8. The auditors'report will be considered in Section 4 of thischapter. Here, we just consider the contents of the directors'reporDirectors'reportThe main items that a directors report must contain arecertain detail about the pany's activities over the previous year, and likelyevents in the ing twelve months. Opinions are expressed by the directorsa brief summary of the financial decisions that the directors have madeincluding the proposed dividend, the amount of shareholders profits retained bythe pany, charitable donations made by the pany and details of any ofthe pany's own shares that have been purchased during the yeardetails of persons who were directors during the year, their shareholdings andtheir other interests in the panyC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsPage 7listed panies also have to include in their directors'report additionalinformation required by the Stock Exchange such as a geographical analysis of turnoverand average time to pay creditoThe Companies Act's accounting requirements run to dozens of pages ofdetailed rules. There is, however, one overriding requirement. That is that thefinancial statements must give a true and fair view". The Act does not definetruth and fairness and so the phrase must be interpreted in terms of normalEnglish usage. There is, however, a growing body of evidence that this is a termof art and that it has a technical meaning for accountantsQuestion 7.3Give the accepted interpretation of"true and fair view'To a large extent, the truth and fairness of the statements can be determined bywhether they ply with all of the rules and regulations which were outlinedabove. It is, however, necessary to exceed the formal disclosure requirementsor to deviate from the rules governing calculation if doing so would enable thepany to give a true and fair view. This requirement to look beyond thecodified rules appears to give the concept of truth and fairness an independentexistenceQuestion 7. 4The sole director of a pany is considering how to state the holding of a SI millionloan to his brothers pany. If his brother's pany continues to service the loanhis own pany is solvent, however if his brother defaults, his own pany isDoes a"true and fair view" dictate that he values the loan at book cost. at market valueor at zero in his accounts?In the United States, following successive accounting scandals in 2001-2 involvingEnron, World Com and others a tough new statute has been introduced. The SarbanesOxley statute (known as Sarb-Ox or SOX) aims to improve the accountability ofmanagers to shareholders and to restore faith in the accounting systemSome panies will be subject to other legislation specific to their type ofindustry. For example, in many countries there are specific rules relating tospecialised businesses such as insurance panies, banks, pension funds andThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 8CT2-07: Introduction to accounts2 The International Accounting Standards board(IASB)2.1 The role of the A sBThe International Accounting Standards Board(IASB) is the body that developsissues and withdraws accounting standards. The standards that are issued bythe lASB are called International Financial Reporting Standards(IFRSs)The International Accounting Standards Board (IAsB) was set up in April 2001. Itspredecessor, the International Accounting Standards Committee (IASC), issuedInternational Accounting Standards(IASs). These are still in effect unless replaced byIFRSInternational standards relate to all panies and other kinds of entities whichprepare accounts intended to provide a true and fair vietThe lasB has no authority to require pliance with its accounting standardsHowever, many countries require the financial statements of publicly tradedenterprises to be prepared in accordance with IFRSs, and where necessary)togive particulars of any material departure from those standards and the reasonsFor example, from 1 January 2005, all listed UK limited panies have beenobliged to use International Accounting Standards for consolidated accountsMany UK panies are electing to use the international standards in place ofthe UK ones and so these are the ones likely to be met in practice. the rest ofthis chapter(and Part two as a whole), reflects the terminology and format fromthe international standardsThe IASB collaborates with national accounting standard-setters in manycountries in order to ensure that its standards are developed with due regard tointernational and national developments. International accounting standardshave helped both to improve and harmonise financial reporting around theworldIFRSS are used in many countries in the world including Singapore, Hong Kong, Russia,most European countries under the jurisdiction of the European Union, and AustraliaQuestion 7.5Why could national accounting standard mittees be driven in a particular directionby international mittees?C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsPage 92.2 The case for and against internationa/ standardsThe system for producing standards and keeping them up to date is fairlyelaborate, and expensive to operate. Some of the arguments which are made forand against accounting standards include the followingArguments FORArguments AGAINSTThey eliminate, or at least reduceThe sets of rules contained in thevariations between panies instandards may not be appropriate tothe way they prepare accounts.all panies in all circumstances.The discussion process leading upStandard-setting may not be entirelyto a standard being issued focusesobjective (some standards in theattention on particular areas forpast have been the subject ofdebate about accounting practice.government pressure or industryThey oblige panies to discloseStandards often allow more than onemore information than thatalternative treatment which negatesrequired by national laws.the attempt to ensure conformitybetween paniesThey allow some degree ofSome standards are so general as toflexibility in a way that legislationbe meaningless, while others are faroften does nottoo detailedThe arguments above relate on the whole to international accounting standards, but they2 could be modified to discuss the case for and against accounting standards generallyWhatever the arguments for and against accounting standards, there is no doubtthat they have greatly improved accounting practice. Before their introduction,different panies in similar circumstances were following pleteldifferent accounting policies, leading to different and inpatible results. Inthe 1960s, there was a series of financial scandals that drew the publicsattention to the flexibility of the accounting rules at that time. In several caseshere takeovers occurred different accountants produced radically differentresults for the same pany. the accountancy profession was publiclycriticised and this led to the formation of the first accounting standard-settingborThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-07: Introduction to accounts3 Typical contents of an annual reports an example, the annual report of a pany listed on the UK Stock Exchangecan easily run to 60 or 70 pages. Much of this is"promotional"material which ispublished on a voluntary basis. The core of the report is, however, subject tothe stringent rules imposed by the Companies Act 1985 and the detailedregulations imposed by the accountancy profession, as discussed aboveThere is no need to learn the detailed content of a typical annual reportIndeed the content varies widely from pany to pany and from industry toindustry. In many financial industries, much of the content explains various financiaratios such as capitalisation and margin. The notes often have intricate information onisk and risk management which can only be understood by industry specialistsIt is, however, almost impossible to make any sense of these rules in a vacuumThe best way to obtain some understanding of the contents of the financialstatements is to obtain one or two sets. Most large panies will havefinancial statements(and annual reports)available on their websitesThe table on the following page gives details of the content found in one pany'sannual reportC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsThe annual report of a particular UK-based multinational ran to 96 pages. thisprisedPContents2-3The directors'biographical detailsa page of" highlights"of financial statements including theprofit and dividend figures and some key trends5An analysis of turnover profit by product area andgeographical area6-9The chairman' s statement to members, including a personalreview of the year gone past and the pany's future10-11 A map showing the pany s world-wide operations.12-13 Statistics showing a thirty-year financial record14-48review of operations prising a series of descriptiveanalyses of each of the pany' s main business segments49-52 Disclosure of matters relating to corporate governance issuessuch as directors'remuneration53-59 The directors'report, which is actually a list of miscellaneousdisclosures required by the panies Act 1985.60-61 A statement of the accounting policies which were used inpiling the ine statement and balance sheet. This mighttypically detail how the pany values its assets, translates itsforeign earnings, recognises its ine and depreciates its stock.62-66 The accounting statements themselves: ine statement,balance sheet, cashflow statement, statement of changes inequity, etc.67A statement of the directors'responsibilities for the financialstatements and the auditors'report68-90 Notes to the accounts. These might typically show further detailon certain items, like the capital gains realised, the costs andexpenses of the business, and management salaries, etc. A long-term(often 5-year )summary of results is also included91-96 A list of the pany's principal UK and overseasabsidiariesThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 12CT2-07: Introduction to accounts4 The auditors' reportIn the UK, every pany is required by the Companies Act 1989 to appointauditors to hold office from one annual general meeting to the next. Theauditors must report to the shareholders on the published accountsAuditors are elected by the shareholders and shareholders approve the auditors'feeThe auditors must ment on whether, in their opinion, the balance sheet andine statement have been properly prepared in accordance with theCompanies Acts and relevant accounting standards, and whether, in theiropinion, the accounts give a true and fair view.The fundamental purpose of the audit report is to add credibility to the financialstatementsThe contents of an auditors'reportThe auditors'report must contain1. a title, identifying the person or persons to whom the report is addressedan introductory paragraph identifying the financial statements audited3. separate sections, appropriately headed, dealing with(a) respective responsibilities of directors and audito(b) the basis of the auditors opinion(c) the auditors'opinion on the financial statements4. the manuscript or printed signature of the auditors, with the address5the date of the auditors'reportThe section described under 3(a) above clarifies the directors'responsibility to ensurethat financial records are properly kept, and that financial statements are prepared inaccordance with suitable accounting policies. The auditors'responsibilities will be toform an independent opinion based on those records and statementsThe section described under 3(b ) makes it clear how the auditors arrive at an opinionC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsa typical audit report for a UK listed pany reads as followsINDEPENDENT AUDITORS' REPORT TO THE SHAREHOLDERS OF XYZ PLCWe have audited the group and parent pany financial statements (thefinancial statements")of (name of entity) for the year ended. which prisestate the primary financial statements such as the Group and parent CompanyIne Statements, the Group and Parent Company Balance Sheets, the groupand Parent Company Cash Flow Statements, the Group and Parent CompanyStatements of Change in Shareholders'Equityl and the related notes. thesefinancial statements have been prepared under the accounting policies set outthereinhave also audited the information in the directors' RemunerationReport that is described as having been auditedRespective responsibilities of directors and auditorsThe directors'responsibilities for preparing the Annual Report, the DirectorsRemuneration Report and the financial statements in accordance with applicablelaw and International Financial Report Standards (FRSs) as adopted by the euare set out in the statement of Directors' ResponsibilitiesOur responsibility is to audit the financial statements and the part of thDirectors' Remuneration Report to be audited in accordance with relevant legalandnd International Standards on Auditing(UK andIreland)le report to you our opinion as to whether the financial statements give a trueand fair view and whether the financial statements and the part of the DirectorsRemuneration Report to be audited have been properly prepared in accordancewith the Companies Act 1985 and article 4 of the IAS Regulation We also reportto you if, in our opinion, the Directors' Report is not consistent with the financialstatements, if the pany has not kept proper accounting records, if we havenot received all the information and explanations we require for our audit, or ifinformation specified by law regarding directors' remuneration and othertransactions is not disclosedWe review whether the Corporate Governance Statement reflects the pany'spliance with the nine provisions of the 2003 FRC Combined Code specifiedfor our review by the Listing Rules of the Financial Services Authority, and wereport if it does not. We are not required to consider whether the boardsstatements on internal control cover all risks and controls, or form an opinion onthe effectiveness of the group' s corporate governance procedures or its risk andcontrol procedures.The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 14CT2-07: Introduction to accountsWe read other information contained in the Annual Report and consider whetherit is consistent with the audited financial statements the other informationprises only [the Directors' Report, the unaudited part of the DirectorsRemuneration Report, the Chairman's Statement, the Operating and FinancialReview and the Corporate Governance Statement]. We consider themplications for our report if we bee aware of any apparent misstatementsor material inconsistencies with the financial statements. Our responsibilitiesdo not extend to any other informationBasis of audit opinionle conducted our audit in accordance with International Standards on AuditingK and Ireland) issued by the auditing Practices board. An audit includesexamination . on a test basis of evidence relevant to the amounts anddisclosures in the financial statements and the part of the DirectorsRemuneration Report to be audited It also includes an assessment of thesignificant estimates and judgements made by the directors in the preparation ofthe financial statements, and of whether the accounting policies are appropriateto the groups and pany,'s circumstances, consistently applied andadequately disclosedWe planned and performed our audit so as to obtain all the information andexplanations which we considered necessary in order to provide us withsufficient evidence to give reasonable assurance that the financial statementsand the part of the Directors' Remuneration Report to be audited are free frommaterial misstatement, whether caused by fraud or other irregularity or error. Informing our opinion we also evaluated the overall adequacy of the presentationof information in the financial statements and the part of the DirectorsRemuneration Report to be auditedOpinionIn our opinion:the financial statements give a true and fair view, in accordance withIFRSs as adopted by the European Union, of the state of the group's andthe parent pany' s affairs as at∴…… and of the group' s and the parentpany' s profit [loss] for the year then ended;the financial statements and the part of the Directors' RemunerationReport to be audited have been properly prepared in accordance with theCompanies Act 1985 and article 4 of the IAS Regulation; andthe information given in the Directors'Report is consistent with thefinancial statementsRegistered auditorsAddressDateo The Auditing Practices Board LimitedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsThe wording of this audit report contains a number of caveats These arehowever, buried in the text of the document and require a very careful readingFor example, the word"opinion"crops up in several places. This is a warningthat the preparation of the statements and the collection and evaluation of auditevidence all involve subjective judgementThere are even more subtle hints. For example, the fact that the report isaddressed to the members of the pany is meant to warn other potentialreaders that the auditor does not accept any duty of care for their use of thefinancial statements and also that the audit work was planned to satisfy theneeds of the shareholders and so could be inappropriate for other purposes.4.2 Variations on the standard reportThe wording of the standard report can be modified if the auditor wishes tohighlight areas of uncertainty or is unable to express an unqualified opinion thatthe financial statements give a true and fair view. There are various degrees ofemphasis of matter paragraphsqualitied opiniondisclaimer of opinionadverse opinionand these are described briefly below.Emphasis of matter paragraphsIf there is a significant uncertainty which has been disclosed in the accountsthe auditor should point this out. However, if the financial statements give atrue and fair view, then the auditor would issue an unqualified opinionQualified opinionThis may be issued where there is a limitation on the information whichauditor has obtained, or the auditor disagrees with the treatment of a matter,the auditor is still able to express an opinion of the financial statementsDisclaimer of opinionIf the auditor cannot obtain sufficient information to express an opinion, adisclaimer of opinion may be issuedThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-07: Introduction to accountsAdverse opinionThis is issued where the auditor believes that the financial statements do nogive a true and fair view and the effect is so material that a qualified opinion isnot adequate to disclose the misleading or inplete nature of the financialstatementsIf a pany fails to ply with the Companies Act, the directors can be required topay for the preparation of a revised set of accountQuestion 7.6Why would a pany want to avoid receiving anything other than an unqualifiedopinion on its accounts?4. 3 The regulation of auditorsThe auditor must belong to one of the recognised supervisory bodies who haveregistered with the Department of Trade and Industry. In practice, the vastmajority of pany auditors are firms of chartered accountants. Thesupervisory bodies are responsible for the supervision and discipline of all ofthe registered auditors whom they accredit. There is a system of visitation andmonitoring of standards and firms which do not achieve a satisfactory standardmay have their registration withdrawnThe profession also regulates the practice of audit by the publication of auditingstandards. The Auditing Practices Board(APB)issues: International Standardson Auditing(ISAs)(UK and Ireland, Practice Notes and Bulletins. If auditors donot ply with standards they may be subject to action from their recognisedsupervisory body. For example, ISA 700 sets out the standard wording of theaudit report as illustrated aboveThere have been two major fears about auditors in recent vearsconflicts of interest (if the auditing firm also acts in an advisory role to thefamiliarity threats (if the auditor has audited the accounts of a pany for manyyears)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsPage 17There is new ethical guidance, which all professional bodies have now adopted. Thereis an overriding requirement for auditors to be conceptually independent of their clientsHowever, the decision as to whether or not an auditor is independent is -at leastUK -a matter which is down to the individual auditor to determine in the light ofown professional judgement and in the light of a prescribed"threats and safeguardapproachQuestion 7. 7Give arguments for and against the following statement: "It should be pulsory thatthe auditors of a pany should be changed at least once every five yearsThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-07: Introduction to accounts5 Accounting conceptsAccounting standards are based on concepts and conventions which havegradually e together and evolved over many years since bookkeeping andaccountancy came into being. In recent years accounting standards bodieshave attempted to put more cohesion behind these concepts and conventionsFor example, the UKs Accounting Standards Board published FRs18Accounting Policies"in December 2000 which sets out the current position onthe development of these concepts and conventions. In recent yearsAccounting Standards have placed greater emphasis on neutrality, rather thanprudence, and there has also been a move away from historical cost towardsfair valuesIn very broad terms, this means revaluing assets (and liabilities) in the balancesheet at the end of each accounting period Any loss on revaluation should beincluded in that period's ine statement. Any gain on revaluation is taken tothe revaluation reserve in the balance sheet, where it is held until the gain isrealised (ie the asset is sold). A consequence is volatility in the financialstatements and so this move is controversial. The examples which follow donot incorporate this practice and students will not be expected to produceaccounting statements which reflect revaluationsWe will however discuss revaluation further below and also in Chapters 8 and 9The 11 accounting concepts we discuss in detail arethe cost concept(often called"historical cost")the money measurement conceptthe business entity conceptthe realisation conceptthe accruals conceptthe matching conceptthe dual aspect concepthe materiality conceptprudencethe going concern conceptconsistencyC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsAs you read each concept, dont just memorise the text- try to visualise what theconsequences of the concept would be if you were drawing up the accounts of a smallmanufacturing pany, billing customers, receiving invoices from suppliers and tryingto plete quarterly accounts at the same time5.1 The cost conceptNon- current assets and goodwill arising on purchase generally appear in thebalance sheet at their original cost less depreciation to date, subject to apossible impairment writedownGoodwill is the amount that is paid for a subsidiary pany over its book value. Thisappears as a non-current asset in the groups accountsUnder IAs 36, at each reporting date, an entity assesses whether there is an indicationthat an asset has been impaired(damaged or weakened )in some way. Wherever thisthe case. the recoverable amount of an asset is measured. The recoverable amount is thehigher of“ fair value less costs of sale” and its“ value in use”( measured as the presentvalue of the future cashflows from the assetFor most non-current assets such as machinery, manufacturing propertiesputers etc, the cost concept dictates that any expenditure in acquiring them is nottaken as a cost in the year in which the asset is purchased. Instead an amount odepreciation is calculated each year and taken as a cost through the ine statementThe asset is placed on the balance sheet, but its value is written down year by year as theoriginal cost is depreciated to zeroThis cost convention ignores changes in the purchasing power of money andcan produce different values for identical items, but simplifies the task ofmaintaining bookkeeping records.Most investment type assets, ie securities, derivatives and ( non-owneroccupied) property, are, however, recorded at fair value(broadly market value)although redeemable fixed- interest securities may be held at amortised cost incertain circumstancesThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-07: Introduction to accountsConsider the followinExampleIf a bond is purchased at f70 per f100 nominal, a strict reading of the cost conceptsuggests that it should be held in the books at this price until it is sold or maturesHowever a more appropriate policy might be to increase the book value gradually fromt70 to f100 over the period to maturity. This avoids a large capital gain on redemptionThis is what is referred to as "amortised cost"in the Core reading above, whereamortisation refers to the gradual""of the asset!The above would still be classed as a book value basis of accountingFor securities held in other panies it would be over-prudent to allow these shares toremain at original cost in the balance sheet if they are worth 10 times what the panypaid for them. That is why"fair values "are permitted for such assetsAs mentioned above, there has been a move away from historical cost towards therevaluation of many assetsIAS 38 says that intangible assets(such as patents and brand names) can be recorded atcost less depreciation or fair value where there is an active marketIAS 39 says that financial assets and liabilities are initially recognised at fair value andshould continue to be if held for trading or classed as "available for saleIAs 40 says that investment property can be recorded at cost less depreciation or fairIAS 41 says that biological assets (living animals and plants)should be recorded at fairvalue less selling costs5.2 The money measurement conceptAccounting statements restrict themselves to matters which can be measuredobjectively in money terms. Again, this simplifies accounting enormously. Italso means that a balance sheet will rarely give even a rough approximation ofthe value of the business because it will exclude such items as the values of thepany 's customer base its workforce and its brand namesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsPage 215. 3 The business entity conceptThe affairs of the business are kept separate from those of the owners. This isperfectly valid in the case of a limited pany, which has its own legal identityIt would, however, also apply to sole traders and partnerships where thebusiness does not exist except as part of the owners'estateIt seems mon sense that the financial transactions of a business entity aremaintained separately from those of the owner. However it is useful to state it as anaccounting concept.5.4 The realisation conceptIne is recognised as and when it is"earned". It is not, therefore, necessaryto wait until the customer settles his or her bill this avoids the fluctuations inreported ine which might arise if everything was accounted for on a cashbasis. It can also create the impression that the business is performing wellwhen, in fact, it is in danger of running out of cash. a business which isexpanding might report ine long before the related cash inflowsThis concept runs alongside the accruals concept by emphasising the fact that profitshould be recognised in the period it is earned, rather than when the financial settlementtakes place. If a pany has sold its products or services, then the sales should berecognised in the accounts. The fact that the pany might not have received paymentis an entirely separate concern. The profitability of the business is measured through theine statement and the cashflow is dealt with through the cashflow statement and theprovision for bad debts5.5 The accruals conceptExpenses are recognised as and when they are incurred regardless of whetheror not the amount has been paid. Again, this avoids the random allocation ofcosts to periods depending on whether the bill happens to have been paid orti uppose for example, that on I February, a drug pany pays the quarterly rental ondevelopment laboratories for the period February, March and April, then pletesits accounts for the year to March. The pany would be justified in allocating onlytwo thirds of the rental payment in the period to the end of MarchThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-07: Introduction to accountsQuestion 7. 8Would it be appropriate to spread the costs of a failed drug development over a 5-yearperiod?5.6 The matching conceptIne and expenses which relate to each other should be matched togetherand dealt with in the same ine statement. From the above two concepts thisshould be for the period in which the amounts were earned/incurredThe matching concept is a mixture of the realisation concept and the accruals conceptExpenditure incurred in generating the ine for a period should be recorded asncurred over the same period ie the expenditure is matched to the ine5.7 The dual aspect concepthe dual aspect concept recognises that every transaction or adjustment willaffect two figures. For example, the purchase of stock for cash will increase theasset of stock and reduce the asset of cash This concept forms the basis forthe double entry bookkeeping systemWe discuss this concept later when we introduce double-entry bookkeeping and the trial5.8 MaterialityThere is little point in providing information which is so detailed as to beunintelligible. The statements can, therefore, be made clearer by showing totalssuch as"administrative expenses"instead of listing every item which makesthiIs headingSimilarly, therpolmakingadjustments which have no real effect on the picture portrayed by the financialstatements. Thus, accountants might report rough approximations for certaincosts rather than waste time calculating more precise figures. What is, or is notmaterial however does depend to some extent on the emphasis which thepany will put on the relevant figures.It is important to note that all transactions in accounts are recorded in an accuratemanner. The materiality concept affects the presentation of accounts when, forexample, some rounding is required on accruals or an error is discovered that is deemedtoo small to warrant reworking the accountsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsMateriality enters almost every aspect of accountancy. It is relevant in deciding whetherto publish accounts in millions rather than to the exact dollar, whether the extra effortrequired to split administration costs by country is justifiable (or whether some broadpercentage could be applied to the overall costs), or whether the extra costs of a fireone factory should be detailed separately in the accounts. The key question whichasked in each case is "would the extra disclosure add to the reader's understanding ofhe business?”In some cases the materiality principle has to be interpreted carefully. For example, if afinancial pany is fined by the regulator for breaching some guidelines, the fineshould be disclosed. It is the fact that the pany is fined that is important forshareholders to understand, even if the amount of the fine is negligible5.9 PrudenceThe preparers of the financial statements should avoid presenting an undulyoptimistic set of results. Thus, the lowest reasonable figure should be stated forprofit or for any of the assets. the highest reasonable figure should be statedfor any liabilities. This means that there is very little danger of the figures lullinganybody into a false sense of security by overstating the pany's strengthsHowever, it is not permitted to include deliberate margins in the financialstatements. Prudence should only be applied in situations where there isuncertainty.This means thprovision is made for all known liabilities, expenses and losses, whether theamount is known with certainty or is a best estimate in the light of thenformation availableprofits are not anticipatedprofits are only recognised by inclusion in the ine statement when realised inthe form of cash or of other assets the ultimate cash realisation of which can bessessed with reasonable certainty5. 10 The going concern conceptIt is usually assumed that a business will continue indefinitely in its presentform. This concept acts as a justification for the limitations imposed by the costconcept because there is little harm in reporting historical figures for value if theassets concerned are unlikely to be sold in the immediate future.The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 24CT2-07: Introduction to accountsThe going concern concept means that the enterprise"will continue in operationalexistence for the foreseeable future'If the alternative to publishing accounts on a"going concern"basis is to present themthe basis that the pany is to be wound up, then the going concern basis has much toremend it. A winding-up basis is not at all representative of the state of a pany(unless it is about to be wound up!For example, specialised machinery can be given a non-zero value even if it would beworthless if the business were to cease tradingDirectors are required to report that"the business is a going concern". If they are in doubt,they should not prepare accounts on a going-concern basis. A series of disclosuresrequired in these circumstances. The auditors will be required to ment on thestatement that the business is a going concern"if they feel that it does not reflect themessage of the financial statements5.11 ConsistencyThe figures published by the pany should be parable from one year tothe next. Accounting policies should not, therefore, be changed from one yearto the next unless there is a very good reason for doing so. Any changes shouldbe highlighted and their impact explainedThe numerical effect of such a change on the panys results for the year must beownThe consistency concept states that accounting treatment of like items should beconsistent within each accounting period and from one accounting period to the nextOften when a pany does alter its accounting treatment of a particular item -usuallybecause its contribution to profit has bee much more important than before, and theprevious treatment is no longer acceptable- it will rework its previous-year profits onthe new basis for parison purposes.a A student remended this way of remembering the 11 conceptsMCMMC BRAD PGC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accounts5. 12 Bringing the concepts togetherTaken individually, each of the concepts would appear to be little more thanmon sense. Most are designed to make the statements easier to prepare(eg the money measurement concept)while other are designed to make thestatements more useful (eg accruals produces more meaningful profit figures)When taken together, however, the concepts often conflict with one another andthis makes their application confusing for accountants and readers of financialstatements alikQuestion 7.9Last year, the XYZ pany sold f100, 000 worth of goods. It received payment fort70,000 of these during the last year, and expects to get paid t25, 000 in the future inrespect of the remainder. XYZ does not expect to receive the remaining e5, 000 becausethe person who owes this money has been declared bankruptHow much should XYZ show in its accounts as sales for last year?The most obvious conflicts are between the concept of prudence and the goingconcern and realisation conceptsseems incongruous to attempt to present a prudent view while assuming thatthe business has an almost unlimited useful life. Similarly, it is hardly prudentto assume that a transaction will result in a positive oute without firstwaiting to ensure that the ine will actually be receivedExampleOn 1 January a sole trader withdraws f100 from the pany bank account and lends itto an employee for one year at a rate of interest payable monthly over the calendar yearWhen preparing its ine statement at the end of the financial year in March it canapply the accounting principles in various waysApplying the realisation concept, it could record the interest payments monthlyas they are earned by the panyApplying the prudence concept, it could record the interest payments only whenthey are receivedApplying the materiality concept, it could treat the loan as a loss in petty cashwhen the loan is made and a profit if and when it is repaidThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-07: Introduction to accountsIn the UK, FRs 18 sets out the principles to be followed in selecting accountingpolicies. The FRS states that the accounting policies selected must be thosejudged to be most appropriate. for the purpose of giving a true and fair viewof the financial position and profit and loss for a period) ". Furthermore, itidentifies two concepts - the going concern assumptions and accruals -asplaying a pervasive role in financial statements.Hence, the Frs requires that:1. financial statements should be prepared on a going concern basis unless(a the entity is being liquidated or has ceased trading, or( b) the directors have no realistic alternative but to liquidate the entityor to cease trading2. financial statements, except for cashflow information, should be preparedon the accruals basis of accountingFRS 18 also requires that the objectives against which the appropriateness ofaccounting policies should be judged arerelevancereliabilityparability, andunderstandabilityReliability enpasses the need for a careful balance to be struck betweenneutrality"(ie freedom from deliberate bias)and prudence in the face ofuncertaintyIn past examinations, short questions have appeared on all aspects of this section of the2 course. For exampleDescribe the different reports the external auditor can give when it is impossible toexpress an unqualified opinion. (April 2001)Discuss the interests of four user groups of financial statements and explain why someof the groups'interests may conflict. "(September 2001)Identify three accounting concepts and explain how each affects the content of thefinancial statements. (April 2002, adapted)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsPage 27Chapter 7 SummaryCompanies publish accounts each year in order to report back to their shareholdersAccounts show how shareholders' funds have been used to generate profitsThe main users of accounting information areequity investorsloan creditorsemployeesbusiness contactsRegulations governing the preparation of accounts are of two main typesthose concerning specific disclosures(mainly covered by the national laws andthose concerning the manner in which items should be valued(mainly coveredby professional standards and conventions)the UK, statutory requirements are based on the Companies Act 1985. Companiesmust producean ine statementdetailed disclosures(or notes to the accountsa directors reportan auditors’ reportThe International Accounting Standards Board(IASB)is the body that develops, issuesand withdraws accounting standards. The standards that are issued by the iasb arecalled International Financial Reporting Standards(IFRSs). All listed UK limitedpanies must use international accounting standards for consolidated accountsThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-07: Introduction to accountsThe auditors'report must state whether or not, in the opinion of the auditors, theaccounts have been properly prepared and give a true and fair view of the state of thepanys affairs. The wording of the standard report can be modified where theauditors want to highlight some uncertainty or are unable to give an unqualified opinionThe categories are:emphasis of matter paragraphsqualified opiniondisclaimer of opinionadverse opinionThe accounts must conform to various accounting concepts, of which going concernand accruals are the most pervasive. The full list of eleven concepts isMoney measurementCostMaterialitMatchingConsistencyBusiness entityRealisationAccrualsDual aspectPrudenceGoing concern.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsChapter 7 SolutionsSolution 7.1The value of the loan to the holder depends on the pany's ability to pay the interestthe loan and to repay the capital at maturity. If the pany were unrestricted, itould borrow more money after the loan issue, thereby increasing the amount of debtinterest to service, and increasing the amount of capital it is required to payBy restricting the pany with a covenant to a certain amount of debt, or a certainminimum interest cover on the loan, the lender is ensuring the future security of hisInvestmentIn addition, the advantage of basing the restriction on accounting ratios is that thecalculation will be both consistent and objectiveSolution 7.2Published accounts are only useful if their content can be relied upon to be a true andfair view of the pany's trading position and prospects. As such it is essential tohave the numbers signed off by an "independent professionalThe auditors are appointed by the shareholders and report to them, so the auditors areompletely independent of the directorsShould the auditor have doubts about the quality of the information, or about the mannerin which it has been presented, then he or she is obliged to ment on anydeficiencies. This helps to ensure that the directors of the pany have an incentive tocontrol the pany in a manner that will be favourably viewed by shareholdersSolution 7. 3There is no remended interpretation. The concept is deemed so fundamental thatcannot be summarised. It is argued that the promulgation of accounting standards arethe accounting professions interpretation of a true and fair view". In the end it is leftin the hands of directors accountants auditors and the courts to determine whatconstitutes a true and fair viewThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-07: Introduction to accountsSolution 7. 4The concept of true and fair view cannot be rigorously applied in this way. running abusiness involves a large human element, which cannot be mathematically orscientifically prescribed. The director must make his own decision as to the likelihoodof default and take all possible steps to ensure that his decision is based on all theavailable information. He can then:value the loan in a manner consistent with the rest of the accounts and make adisclosure about the likelihood of default and the consequences in the notesvalue as above, but make a provision to reflect his opinion on the likelihood ofdefaultwrite the loan off as a prudent measure-this would occur in the situation thathis brothers pany is on the verge of bankruptcy. However in thesetances his own pany would no longer be a going concern and theconcept of true and fair would have to be reinterpretedSolution 7.5More and more of the worlds largest panies are multinational. That applies to theirspread of business, trade partners, shareholders, regulators, and to the actual markets onwhich their shares trade. When a pany wishesshares to trade on a particularstock market, its accounts must first ply with the local accounting standardsLikewise, if its accounts are to be used by its trading partners abroad, they have to be ina form which allows parison with other similar panies in the marketather than produce accounts in every local standard, most multinational panieswould choose to have a global standard that applies in all countries. The support forsuch a standard has given LASs and ifrSs enormous power over the last decade. Fornational standard-setters to depart from these global standards is futile becausepanies will choose to report on the global standard(which guarantees access to allmarkets)rather than the national one(which guarantees access to only one market)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-07: Introduction to accountsPage 31Solution 7. 6Anything that reflects badly on the pany can reduce its credit rating and increase itscost of borrowing. Anything that reflects badly on the management team controlling thepany can lead to them being replaced or taken over.Management will therefore, for personal and corporate reasons, wish to avoid receivinanything other than an unqualified set of accountsSolution 7.7Arguments forThere is an inherent problem with the concept of auditing in that the auditing panyis paid for its work by the pany it is expected to pass ment on. In order toensure that the auditors opinion is not swayed by the desire to keep the client, it wouldbe wise to force a change on a regular basis. Likewise from the panys point ofview, if an auditor audits the accounts for a long period, it may be too close to thepany, and not“‘ see the wood for the treesArguments againstIt is arguable that an auditor builds up expertise in the financial accounts of a panyover the years. It should therefore get better at auditing the accounts as the years go byIn addition, there are remarkably few big auditing firms, and it may be argued thatrotation of auditing firms would not increase the independence of the opinion, only theexpense and the bureaucracyThere is no legal or professional onus in the uk for auditing firms to rotate -afterrecent consultation, it was decided that this did not hold any real benefits for clientsand was impractical, given the restricted nature of petition in the listed panyaudit market. However, under the new ethical guidance, there is a presumption foristed panies, that the engagement partner(the actual auditor) should rotate afterfive years and should not return to the engagement until a period of five years haelapsed. However, some degree of flexibility in the timing may be necessary if, forexample, the person's continuity is especially important because there will be majorstructural changes in the client pany, or if the auditing firm is very small. Whererotation does not occur, other safeguards should be applied to reduce the threat to anacceptable level, eg the use of a professional accountant not associated with theauditing teamThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 32CT2-07: Introduction to accountsSolution 7.8would not be consistent with either the prudence principle nor the accrualsprinciple. If the drug has failed, then the next 5 years do not have anything to do withthe expenditure-it should be recognised immediatelySolution 7. 9Prudence means that the amount of f5,000 should not be included in the total figure fosales". The accruals concept means that the t25,000 that will be paid in the future can beincluded. Therefore one answer is i95.000. An alternative solution. more in line withbest accounting standards would be to show sales of f100. 000 with a deduction of t5. 000as a provision for bad debtsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsPage 1Chapter 8The main accountsSyllabus objectives(viii) Describe the basic construction of accounts of different types and the role andprincipal features of the accounts of a pany3Explain the purpose of abalance sheetine statementashflow statementand of the notes to the accountsConstruct simple balance sheets, ine statements and cashflow statements0 IntroductionWe now move on to examine the main accounts. We will look at the purpose andconstruction of the balance sheet the ine statement the cashflow statement and thestatement of changes in equity. We will also consider the notes to the accountsThis chapter is quite difficult. There are lots of new terms to learn. Once you have readand understood how to pile a set of accounts, you need to practise drawing up a set ofaccounts for yourself. There are lots of questions in the Question and Answer BankThe examination is likely to test your knowledge of key definitions eg working capitalyour understanding of key concepts eg the accruals concept; and your ability to constructthe main accounts and parts of themThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 2CT2-08: The main accounts1 The balance sheetThe balance sheet summarises the pany's financial position. It must beremembered that the balance sheet is a snapshot of events at one point in timeEffectively, the balance sheet consists of two listsa list of everything owned by the businessa list of the various sources of finance used to fund these acquisitionsEverything of value which is owned by a business is called an"asset". Financecan be provided by the owners of the business (capital")or by third parties(“ liabilities")Logically, everything owned bybusiness must have been paid for bysomeone. Similarly, all amounts invested in or loaned to the business must beepresented by somethingThere is, therefore, a simple relationship between assets, liabilities and capitalAssets Capital LiabilitiesThis is called the balance sheet equationThe balance sheet format shown on the following page plies with theinternational standardsThis format follows the balance sheet equation above and contrasts with the UKtandard approach which divides into net assets (assets minus liabilities) andcapital. There are also differences in terminology, includingnon-current assets(fixed assets)inventories(stocks)trade receivables(debtors)In practice, there are three main formats in which the balance sheet is writtenAssets= Capital liabilitiesAssets- Liabilities= CapitalNon-current assets Net current assets=Capital long-term liabilitieswhereNet current assets= Current assets- Current liabilitiesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsPage 3Balance sheet for XYZ Ltd as at 31/12/YYASSETSNon-current assetsProperty, plant& equipmentIntangible assetsCurrent assetsnventoriesTrade receivablesOther current assetsTotal assetsEQUITY AND LIABILITIESShare capitalOther reservesRetained earningsTotal equityNon-current liabilitiesLong-term borrowLong-term provisionsTotal non-current liabilitiesXCurrent liabilitiesTrade and other payablesShort-term borrowingsCurrent portion of long- term borrowingsCurrent tax payableShort-term provisionsTotal current liabilitiesTotal liabilitiesTotal equity and liabilities()The amounts shown as() would be the same Some of the categories may not meanmuch to you at this stage. We explain them in the rest of this sectionThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 4CT2-08: The main accounts1.1 Non-current assetsThe distinction between non-current and current assets has more to do with themotive behind their acquisition than their nature. Non-current assets usuallyhave long lives and are bought with the intention of using them in the businessNon-current assets are often known as fixed assetsTangible AssetsThere is usually a great deal of information about the figure for tangible non-current assetsThese usually include, land, property, machinery, vehicles etcTangible non-current assets are generally valued at cost less depreciationDepreciation is discussed in Chapter 9. We give a very brief example here todemonstrate the conceptExampleFour years ago, a pany purchased a machine for t130,000 which was estimated tohave a useful life of twelve years, after which it would have a residual scrap value ofE10,000. The value of the machine to be shown in the balance sheet, using the"straightline"method of depreciation30.0000.000=130.000-4=£90.000The straight line method and the declining balance method of depreciation will bediscussed in Chapter 9Notice that the value of the asset is recorded at cost less accumulated depreciation to date.Depreciation has very little to do with reflecting the"true " value of the assets inthe balance sheet. Instead, it is an attempt to write the cost of the assets off asan expense over their estimated useful lifeNot all tangible assets depreciate in value. Most panies assume that land(but notbuildings) has an infinite life. Land is often revalued in the balance sheetC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsPage 5Intangible AssetsIntangible non-current assets are non-current assets that literally cannot betouched. The most mon type of intangible asset is goodwill. This ariseswhen a pany buys another pany for more than the residual balancesheet value of the target pany. The difference between the price paid andthe balance sheet value is the goodwillThe residual balance sheet value is: total assets less total liabilities, ie the capital. UnderIFRS 3, goodwill is subject to an annual impairment testingPossible intangible assets include research and development costsconcessions, patents, trade marks and brand namesIntangible assets may be recorded at fair value where there is an active marketResearch and development costsA research pany which has developed a product it intends to market over theing years might show the research and development costs on the balance sheet as anintangibleConcessions, patentsA pany can buy the rights over a particular product or discovery. A few paniesshow such rights as an asset. a television pany that owns the franchise to broadcastover a certain period of time might class this expenditure as an intangibleTrade marks and brand namesSimilarly, a few panies claim that their trade marks and brand names are valuableassets which should be shown in the balance sheetMcDonalds is the owner(and avid protector) of a famous brand name. The brand nameMcDonald's is sufficient to guarantee a certain volume of customers, and is worth a greatQQuestion 8. 1Give an example of an intangible asset that a recording pany might have on itsbalance sheetThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 6CT2-08: The main accountsInvestmentsNon-current asset investments may consist of interests in other panies, inthe form of shares, loan stock, debentures, or straight loansInvestments will be shown under the non-current assets heading only if the panyintends to hold those investments for a reasonable period of time, say more than a year.Most panies do classify most of their investments as non-current assetsThey are normally shown at market value (see Chapter 7, Section 5. 1). Wediscussed the problem of valuing financial assets when discussing the cost concept inQuestion 8.2How might financial assets sometimes be valued in the balance sheet?RevaluationThe problems associated with the valuation of assets at cost less depreciationcan be reduced slightly by the regular revaluation of non-current assets, mostnotably land and buildings.We will discuss revaluation in detail in Chapter 9Thus, the balance sheet total for non-current assets may consist of a mixture ofcosts and valuations, dating from a variety of accounting periods, and all lessdepreciation charged since the date of acquisition or valuation the figure will,therefore, have an arithmetic precision but will usually be absolutelymeaningless for decision-making purposes1.2 Current assetsCurrent assets are cash and items which will be converted into cash in thenormal course of businessInventories ( stocksIn accounts, the term inventories (or stocks) includes raw materials,consumables, work in progress and finished goods awaiting sale. Inventoriesare shown in the balance sheet at the lower of cost and net realisable valueC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsPage 7Trade receivables ( Debtors)Trade receivables (or debtors are the amounts which the pany is owed byits customers. The trade receivable heading may also include amounts dueunder bills of exchange receivableOther current assetsUnder current assets, the other current assets heading might include, forexample, money held on short-term depositRevaluationThe figures for inventories and trade receivables should be adjusted to take intoaccount any anticipated losses due to obsolescence or deterioration in the caseof stocks, and likelihood of default in the case of debtors1.3 EquityEquity was previously referred to in this chapter as capital. It is sometimes known asthe shareholders' Fund. It is the amount contributed by the shareholders in the form ofshares and in the form of reserves. It is the net value of the pany ie its assets less itsliabilitiesShareholders'equity can arise in a number of different ways. Some iscontributed directly in the form of payments made for the purchase of shares(share capital). Most of the remainder will be generated from trading activitiesThis consists of profits which have not been distributed in the form of dividendsshare buybacks(retained earnings)In brief the capital prisesshare capital the nominal value of the shares issuedshare premium account the amount raised above the nominal value ofthe shares issuedthe revaluation reserve the amount by which the non-current assetshave been increased in valuethe retained earnings the amount of profit ploughed back or retained by theThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 8CT2-08: The main accountsWhen assets are revalued the non-current assets in the balance sheet increase in valueThere must, therefore be a corresponding increase in the equity of the business. This isnormally shown in the revaluation reserve1.4 LiabilitiesLiabilities are analysed according to their date of maturity.Current LiabilitiesBalances which are due within one year are classified as currentNet current assets (or working capital) is defined as current assets less currentliabilities. It therefore shows the amount that the business has in cash or near-cashhaving deducted the claims on that cash in the form of current liabilities. This termnot usually used in the balance sheet but it is widely used to indicate the liquidity of thebusiness. We shall discuss liquidity further in Chapter 13We now describe the subheadings that might be expected under the heading"CurrentLiabilities”Trade payables (or creditors)As with trade receivables (debtors), the amounts are always included in the balance sheetat their face value, not at their present value. This includes amounts owing for goodsalready received, electricity bills owing etcShort-term borrowingsAny overdraft(negative current account balance) is shown at face value. The amountshown is the amount actually overdrawn, not the maximum overdraft limit that thepany might have agreed with its bankers. Short-term borrowings could also includebills of exchange payableCurrent portion of long-term borrowingsLoans are usually entered in long-term liabilities, but they will be entered in currentliabilities if they have to be repaid within one yearC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsPage 9Current tax payableA pany may have a provision for "deferred tax. This is tax which will beepayable, but not in the year being reported on. If it has to be paid within a year, then it is acurrent liabilityShort-term provisionsWhen a pany receives approval from its sharcholders to pay a dividend, the dividenddue is recognised as a liability until it is paid. If the dividend payment date is within thenext year then this is a current liability. The treatment of dividends is described further intion 2. 7Non-current liabilitieslong telities which are not due within one year are classified as non-current (orterm)Long-term borrowingsThis includes finance leases, medium-term bank loans, long-term unsecured loan stock,debentures and Eurobonds. All loan stock is shown at its nominal (or par) value. Mostloans are issued at the nominal value or below. Any difference between the cash actuallyraised and the nominal value will be allowed for as part of the residual item, under theheading"other reserves". If the bank (or other institution) charges a fee, this reduces thecash raised and is deducted from the "other reservesLong-term provisionsThe figure in respect of long-term provisions will include the estimated liabilitiesin respect of deferred taxation and other matters such as pension mitmentsThese differ from the term loans and obligations under finance leases(includedin long-term borrowings)in that the actual amounts and timing of thesepayments are subject to some uncertainty. They are, nevertheless, liabilities andshould be shown as such in the balance sheetA pany may show a provision for future pension costs if it has failed to set asidesufficient funds to meet its pension scheme's liabilities. Exactly what pension costs needto be provided for is beyond the scope of the syllabusIn addition to the above the pany can have contingent liabilitiesThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accountsContingent LiabilitiesWhere the liability is only a potential one-not even likely-it is not shown on the balancesheet, although such"contingent liabilities"must be disclosed in the notes to the accountsExamples of contingent liabilities include guarantees given on goods sold and potentialourt claimsQuestion 8. 3Classify each of the following items, which can appear in a financial statement, as anon-current asset(NA), a current asset (CA), a non-current liability (NL),a currentliability(Cl)or as capital(C)CashTrade receivableBuildingTax dueTrade payableInventoriesDividend approved but not paidOrdinary sharesDebentureC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsQuestion 8. 4The following data was taken from the records of abc plc and relates to the values ofthe pany's assets, liabilities and capital at 3 1st December 2007Organise the items to form the pany's balance sheet as at 3 1st December 2007.£000InventoriesTrade payablesMachineryMachinery(accumulated depreciation)132CashLong-term loans289Ordinary share capital200Trade receivables195Tax pr67Dividend provisionRetained earnings350Other reserves100The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 12CT2-08: The main accounts2 The ine statementThe ine statement provides an insight into a pany' s trading activities. Itpares the ine generated from trading with the costs associated withearning that ine, the difference being the profit or loss for the year.This was formerly known as the profit and loss accountThe following is an ine statement that plies with the internationalstandardsRevenueXCost of salesGross profitXother operating ineXDistribution costsAdministrative expensesOperating profitXFinance ineXFinance costsNet profit before taxXTax expense(X)Profit after taxProfit for the period attributable to equity holders of the panyXXxEarnings per share for profit attributable to equity holdersA dividend of xp per share was paid to ordinary shareholders during the year.We now look at each item in detail2.1 RevenueRevenue is recorded when it is earned (not necessarily when it is received)inaccordance with the realisation concept. Revenue can be called turnover or salesThe cost items(which follow) are usually recorded as they are incurred (not necessarilywhen they are paid)in accordance with the accruals conceptC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accounts2.2 Cost of salesCost of sales reflects the raw material, ponents, wages and salariesexpended in producing the goods sold. Changes in stock levels(both finishedgoods and raw materials) will need to be included, as will the charges fordepreciation(see Chapter 9 ).According to the matching concept, only the costs incurred in generating the sales mustbe included in the accountQuestion 8. 5A shop buys t20, 000 worth of goods during 2007. It began the year with t2, 000 worthof stock and ended the year with f7,000 of stock. Assuming there are no other items tobe included in the cost of sales what is the shops cost of sales?The cost of sales can be found asCost of stock soldCost of stock sold couldopening stockbe calculated asless increase in stockclosing stockWages and salaries of production staffDepreciation of non-current assets2.3 Distribution costs and administrative expensesDistribution costs include costs associated with sales, distribution andadvertising. Administrative expenses include associated wages and salariesand directors'remuneration. These costs are sometimes called overheads. They arnot strictly related to production. In the short run, their value will not normally changewith the level of productionIn practice, it is sometimes difficult to distinguish between costs related to production(direct costs) and those not related to production (indirect costs). For example,electricity might be used to power the production machinery or to heat and light theoffices. Depreciation of equipment sometimes arises from wear and tear and thus fromproduction, but sometimes it arises from obsolescence or simply from the passage oftimeThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accountsIn an exam question, if necessary, make an assumption about whether a cost is direct orindirect and say why you have made that assumption2. 4 Finance ineThis will include ine from investments such as rent from property, interest onbonds. dividends from shares25 Finance costsThis category includes interest payments made on loans. It is important that these costsare seen clearly in the ine statement so that investors can see the scale of the interestpayments and the pany's ability to pay them2.6 Tax expenseThe tax charge in the ine statement arises because panies paycorporation tax on their adjusted net profit figures. These adjustments may bedisputed by the tax authorities and may be revised after the publication of theaccounting statements. The estimate for corporation tax forms the core of thecharge in the ine statement, although there are usually additional charges.The tax charge in a pany 's accounts rarely equals exactly(corporation tax rate)x(pre-tax profit)There are a variety of reasons for this(most of which were discussed in Chapter 3), butthe main reasons arethe tax authorities will calculate the ine statement a second time usinsofficial"capital allowance "rates instead of depreciation charges for non-currentassets. This will produce a different profit and thus a different tax chargeLikewise, some of the expenses that a pany brings in to its ine statementmight not be allowable in a tax putationa pany will sometimes have disputes or negotiations with the tax authoritiesover tax issues, and these can cause tax to be"provided for"rather than"paidwhile the dispute is settledcarried forward losses from previous years can reduce the current year tax billC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsDetails of the adjustments made to accounting profit to arrive at taxable profit weregiven in Chapter 3 Section 2Where a pany believes its current-year tax figure does not reflect its long-term taxliability, it will create a provision for deferred tax in the balance sheet2.7 Dividends paidThe final profit figure for the year is used to pay dividends. It would be unusualfor the pany to distribute all of the profit in this way. Profit may also bedistributed by the pany buying back sharesThe way dividends are shown has changed in the recent past. For accountingperiods starting on or after 1 January 2005dividends proposed (dividends announced by the pany's directorsbut not yet approved by the shareholders, which are planned to be paidafter the pany' s year end) are disclosed only in a note to the accountsas they cannot be treated as definite until approved at the pany 'sAnnual General Meetingdividends paid should be shown as a note at the bottom of the inestatement, in the statement of changes in equity, in the cashflowstatement and in the notes to the accountsThe profit for the period is"retained"within the business as part of the ownerscapital and transferred to the retained earnings part of the balance sheet.What happens after dividends are approved?The accounts are drafted prior to the approval of shareholders at the Annual generalMeeting with the dividends being shown as described above in the Core ReadingOnce the dividends are approved at the AGm, an approved set of accounts can be drawnup. If dividends are approved and paid immediately they may appear as a note to theine statement and will be deducted from the cash balance and from the retainedEarning in the equity section of the balance sheet. If they are approved and not paidthey may appear as a note to the ine statement, will be deducted from the retainedEarning in the equity section of the balance sheet and will appear as a current liability inthe balance sheetThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accounts2.8 Categories of profitThe profit figure is normally calculated in three stages. Gross profit is thedifference between the selling price of the goods and services which provide thebasis for the pany,s main trading activities and the cost of sales. Operatingprofit is usually defined as profit earned after all expenses except finance costsinterest. Net profit before tax is the operating profit adjusted for financingnterest)costs and ine. Profit after tax is this net profit after deduction ofThe gross profit figure gives an insight into the pany's pricing policies. Thedifference between cost and selling prices represents the contribution towardthe non-trading expenses and profitAnother version of the net profit figure that is useful is net profit before tax and interest,ie operating profit plus finance ineThese distinctions will bee important when we e to analyse the accounts inPart 3 of the courseWe will see later in this unit that profits and cashflows are two quite differentthings. Thus, the link between retained profits and bank balances is, at best,tenuous2.9 Earnings per shareCompanies are obliged to calculate the earnings per share(EPs)figure anddisclose it on the face of their ine statements. EPs is equal to the earningsattributable to the ordinary shareholders divided by the number of ordinaryshares in issueEarnings is the profit that is available for distribution to the ordinary shareholdersIf the pany raises all its share capital from ordinary shares, the earnings available fordistribution to the ordinary shareholders will be equal to the amount of profit after taxIf the pany raises some share capital from preference shares, then earnings will benet profit after tax after the deduction of preference dividendsWe will examine earnings per share in more detail in Part 3 of the courseC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsPage 172.10 Realised capital gainsIf the pany sells an asset for more than its book value, it has made a capital gainThis realised capital gain is added to the pany's operating profit. Realised capitalgains from the pany's sale of assets(net of losses)are subject to capital gains tax,which, for panies, is levied at the corporation tax rate. The details for calculatingapital gains tax were given in Chapter 3(Section 3)2.11 Revaluation of assetsliabilitiesAs mentioned in Chapter 7 Section 5), the move towards "fair valueaccounting, with the recognising of revaluations in the ine statement hasproved controversial. As an example, if you look at ine statements for aninvestment institution you will see items such as Gains from investments heldat fair value"split intoRevenue"-for ine and realised capital gains, andCapital-for unrealised gains in the ine statement.Revaluation of non-current assets is the practice of recording non-current assets atmarket or fair value. For example, a building could be revalued at t2m(from flm),sothe value of the pany's assets in the balance sheet increases by flm. How is theimbalance in the balance sheet resolvedThe traditional method has been to increase the revaluation reserve(in the equity sectionof the balance sheet) by Elm. This method has no impact on the ine statementHowever, recently there has been a move towards recognising the increase in the asset'salue as a""in the ine statement. In this case, this would be done by includingthe iten“ gains from investments”of£ Im in the ine stateincrease in retained earnings and hence reserves. These are unrealised capital gainssince the pany has as yet received no payment for themTo understand the impact of this method on reported profit, consider the followingproperty development pany. Its profit before tax, valuation and exceptional itemsfor the six months ending June 2006 was t59m. Its profit before tax was $490.5m. Asthe pany mented in its interim report: "Reported profit before tax includes otheritems that are unpredictable by their nature, such as revaluation gains on investmentproperties and the movement in fair value of derivative financial instrumentsInclusion of these items can create considerable volatility in the ine statementThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accountsThe IASB is currently considering a two-statement approach to the ine statement toavoid the problem mentioned above. The second statement would be a statement ofrecognised ine and expense and would cover revaluation surpluses, gains and losseon financial instruments, foreign exchange gains and losses on the net interest in aforeign operation, and actuarial gains and losses on defined benefit pension plansQuestion 8.6The following data relates to XYZ plc for the trading year ending 3 1st December 2007£O00sAdvertising expensesRevenue1,135Stock at 31st december 2006Interest paidInterest receivedDepreciation of machineryStock at 3 1 st December 200738Wages and salaries of production staffWages and salaries of distribution staff278Wages and salaries of administration staffP300Directors remuneration135Dividends paid in respect of year ending 31 December 2006 30Produce the pany's ine statement for the year, assumingcorporation tax is 28%the pany proposes a payout ratio of a third, ie to distribute a third of thisyear's earnings to shareholdersthe number of ordinary shares in the pany is 200,000C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accounts3 The cashflow statementThe cashflow statement is not a requirement of the Companies Act 1985. However it isa Financial Reporting Standard(FRs 1) and an International Accounting Standard(IAS 7) and has been since 19923. 1 Why is the cashflow statement needed?To show cash movementsThe cashflow statement is intended to supplement the ine statement andbalance sheet. the ine statement and balance sheet are useful statementsin their own right. They do not, however, provide a sufficient insight intomovements in cash balances. This is unfortunate because even profitablepanies will collapse if they are not sufficiently liquidThe bank balance is, of course, disclosed in the balance sheet. It is easy to seewhether the balance has changed since the end of the previous year It ishowever, difficult to identify the major causes of such changes. Shareholdersand other readers require a more structured description of the cashflowsThe cashflow statement is intended to answer the following types of question:Why has the bank overdraft increased, despite the pany having had aprofitable year?Is the pany capable of generating cash, as opposed to profit, from itstrading activities?What was done with the loan which was taken out during the year?Cashflow statements show where the money has e from, and where it has goneThey ignore the accruals conceptCash is importantVery few businesses could survive a prolonged cash outflow. It is often thisrather than lack of profits which causes panies to file for bankruptcyCash may also be important for the opposite reason. Because most panies ought tobe able to earn a higher rate of return on their assets than on cash, a pany thatpassively holds large amounts of cash may not be making the best use of its resourcesSo, a clear statement of a pany's cashflow position allows shareholders to checkwhether the pany is being run efficiently(ie not holding too much cash) as well aschecking on solvency(ie holding too little cash ). Cashflow statements help focus on thechanges in a panys holdings of cashThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accountsProfit is not the same as cashThe profit figure for the year is unlikely to bear any resemblance to the increaseor decrease in the pany's bank balance or total for working capital over thatperiod. Several entries in the ine statement, such as depreciation, do notinvolve funds. Furthermore the ine statement recognises credit sales andpurchases before any cash changes hands. Conversely, many receipts andpayments, such as the proceeds of share issues and loan repayments, have noimmediate impact on profit. It is possible for a pany to trade profitably andstill run into liquidity problems.A pany can be very successful and profitable in terms of the ine statement, yetnot be able to find enough cash to finance its day-to-day activities. The pany couldbe selling its goods in large quantities but building up large amounts of trade receivables(debtors)and overdrafts as the pany pays its suppliers and its other expenses but itscustomers are slow to pay their billsThe increase in a pany's cash holdings will differ from the accounting profits shownin the ine statement. The main reason for this difference is the application of theaccruals principleQuestion 8.7Give an example of how the accruals concept can cause the cashflow statement and theine statement to differ from one anotherC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsPage 21Question 8. 8State the immediate effect of each of the following events on a panys pre-taxaccounting 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 valued) increasing the depreciation chargee) 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 dividendsc paying a creditor.Less subjective nature of cashflow statementThe preparation of a cashflow statement is open to less interpretation than thepreparation of the ine statement. For exampleprofits in a ine statement can be distorted if adjustments are made directlyto the balance sheet, without a corresponding entry in the ine statementExamplePolly Peck, which ran into trouble in 1990, illustrates this application of"creativerell. The pany borrowed money in strong currency countries whereinterest rates were low, and used the proceeds to invest in high inflation economies withhigher money returns but weak currencies. In the long run, what they gained on interestrates they would lose on currency movements. However, all they showed in the inestatement were the high local currency investment returns and low strong currencyborrowing costs- so they appeared very profitable. The currency losses were shown bybalance sheet adjustments rather than losses in the ine statement. eventually thisapparently profitable pany did run out of cash. This would have shown up carlierif they had been required to produce cashflow statements(but cashflow statements onlybecame a requirement of good practice in 1992)The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accounts2. in determining"profits "subjective judgements are often needed, eghow much provision should be made for bad debts?which method of depreciation should be used?how should we value stocks?how should we interpret the accruals concept?In contrast, there is much less interpretation involved in preparing a statement ofcashflows. Either you have spent the cash or you haventQuestion 8. 9Explain in detail how and why the following items can be interpreted in different wayswhen panies report their profits(1) valuation of inventories(stocks)(ii) assessment of depreciation3.2 The structure of a cashflow statementThere are three sections to the cashflow statementcashflows from operating activities- starting from operating profit andreconciling operating profit to cashcashflows from investing activities -acquisitions and disposals of long-termassets and other investments not included in cash equivalentcashflows from financing activities changes in the size of equity capital andC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsThe following is an example of a cashflow statement:£000sCashflows from operating activitiesCash generated from operations33.100Interest paid(9,200)Td(14,500)Net cash generated from operating activities9,400Cashflows from investing activitiesPurchases of property, plant and equipment(9,800)Proceeds from sale of property, plant and equipment6400Purchases of intangible assets(3,000)Loans granted to related parties(1,300)Loan repayments received from related parties100Interest received1,200Net cash used in investing activities(6,400)Cashflows from financing activitiesProceeds from issuance of ordinary shares1,000Proceeds from borrowings8.500Repayments of borrowings(10,000)Dividends paid to panys shareholdersNet cash used in financing activities(11,500)Net (decrease)/increase in cash, cash equivalents and bank (8, 500)overdraftsCash, cash equivalents and bank overdrafts at beginning of the year 30,000Cash, cash equivalents and bank overdrafts at end of the year21.500The details of the calculation of cash generated from operations would normally beshown as a note. (See next section.)We will look at the three sections of the statement in turnThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 24CT2-08: The main accountsNet cash generated from operationsThis shows that the pany generated cash inflows of E9. 4m from its tradingactivitiesThe starting point for this figure is the operating profit from the ine statementVarious adjustments have to be made in order to find the cash generated from operatingactivitiesThe cash generated from operations is determined asOperating profit33,000Adjustments forDepreciation18,000Changes in working capitalInventories(7,000Trade and other receivables(1,500Trade and other payables(9,400)Cash generated from operations33,100The operating profit figure in the ine statement includes an accountingadjustment in respect of depreciation. The cashflow related to that expenseoccurred when the non-current assets were purchased.Depreciation has been added back in to the operating profit before calculating the"cashgenerated from operating activities" because depreciation is not a cash itemThe pany's trading activities also include transactions involving inventoriesstock), trade receivables(debtors) and trade payables(creditors). These canaffect cashflows without affecting profits. If, for example, the pany receivedE100 from its debtors at the start of the year, made sales of E1,000 during theyear and was owed E150 at the year end it would have received cash from itsdebtors of f100+ E1,000-E150 E950. Thus, it would report ine of E1,000even though cash takings were less because some of the sales had resulted inan increase in debtors rather than an inflow of cashTwo more deductions must be made interest paid and tax paid- in order to arrive atnet cash generated from operating activitieThe other headings on the statement deal with cashflows which arise from nontrading activities: investing activities and financing activitiesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsInvesting activitiesThese can include the followingpurchase and sale of non-current assets, property, plant and equipmentplus intangible assets, like patentsreceipts of interest and dividends from investmentstransactions involving"liquid"assets other than cash, such as short-termnvestments in securitiesFinancing activitiesThese can include the followingpayment of dividends to the pany's shareholderscashflows arising from the repayment of loans and from fresh borrowingand the issue of sharesThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accountsQuestion 8 10Using the information given below, draw up LoadsaMoney's cashflow statement for2007During 2007, LoadsaMoney had the following items of ine and expenditureincrease in stocks of finished goods13,500taff cost47,300ine from Waddsa Cash dividends4.200turnover362.000increase in cash23,780dividends paidincrease in work-in-progress2,100nterest received on 3-month bank depositinterest paid on loan stock5.5002007 sales for which payment not yet received 71,000payments for 2006 sales received in 200763,0002007 raw material purchases not yet paid for 37,0002006 purchases paid for in 200740,000The pany bought 3 bank note printing machines in January 2007 for 535,000 eachThe total depreciation charge for 2007 was E22, 450On 1 January 2007, the pany had t50,000 in cash and E98, 000 in a three-monthbank deposit. by 3 1 December 2007, it had a f73, 780 in cash and f95,000 in threemonth bank depositLoadsaMoney's operating profit for 2007 was f191, 850C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsPage 274 Statement of changes in equitya further requirement of the international standards is a statement of changes inequity. This summarises the changes in the capital and reserves attributable toequity holders of the pany over the accounting period, and so reconciles theamounts shown in the balance sheet at the start and end of the periodAn example for a one-year period is given belowAttributable to equity holders of the£000ShareOther RetainedTotalcapital reserves earnings equityBalance at 1 January 200X-130.00010.00015,00055,000Fair value gains and (losses),net oLand and buildings2,0002,000Depreciation transfer,land and buildings750(750Net ine/(expense1,2501,250recognised directly in equityProfit for the year50005,000Total recognised ine for1.2505.0006,250200X1Dividends paid(3,000)(3,000)Issue of share capital10,000Balance at 31 December 200X-140.00011,25017,00068,250Notice the revaluation of land and buildings is recognised in the " other reservesThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accountsQuestion 8 11Produce a statement of changes in equity for 2007 for Planet plc, given the followingequity sections of the balance sheets for 31 December 2006 and 3 1 December 2007 plusnotes31 December 200631 December 2007£O00s£000Share capital (50p shares) 800Share capital (50p shares) 1,000Other reserves200Other reserves400Retained earnings130Retained earnings600Total equityTotal equity2,000NotesDuring the year, 400,000 new shares were issued @75,2. On 30 June 2007, the pany's land was revalued. Its book value at the timewas E500.000. This increased to f600.000 at fair value. This increase isrecognised in the revaluation reserve. There has been no depreciation since therevaluation3. The profit after tax for 2007 was f120, 0004. Dividends for 2006 of t20,000 were paid during 2007C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accounts5 Notes to the accountsAs noted in Chapter 7, UK legislation requires panies to produce accountswhich include detailed disclosures - appropriate explanatory notes andadditional information. These are normally presented as a series of notes to theaccountsThe notes will cover.details of the accounting policies used in preparation of the financialstatementsdetailed analysis of balance sheet itemsdetailed analstatement itemsdetails of post-balance sheet events.In addition, panies will normally disclose, voluntarily, additional informationdesigned to help the readers of the accounts to gain a true and fair view of theposition of the pany.In the past, this area of the course has been examined by a variety of questionsMultiple-choice questions have often been used to test definitions and classificationsShort questions have sometimes been asked about the difference between profit andcash. Long(20-mark) questions have often been asked on the construction of inestatements, balance sheets and cashflow statements. Candidates have usually beengiven information drawn from a trial balance(see Chapter 10)and asked to constructThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accountsThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsPage 31Chapter 8 SummaryThe balance sheetThe balance sheet is a snapshot of a pany's financial position at a moment in timeIt shows what the pany owns(its assets), what it owes(its liabilities )and its capitalCapital liabilities= AssetsThe assets are made up of non-current assets, both tangible eg machinery and intangibleeg trademarks, and current assets(cash and items that can be quickly converted intocash eg inventories(stocks ), trade receivables(debtors))The liabilities are made up of non-current liabilities(amounts falling due after one yearand current liabilities(amounts falling due within one year)Capital (or equity) consists of share capital, other reserves and retained earningsThe ine statementThe ine statement shows the profit or loss generated by the pany over a periodof time, usually a year. The ine statement is prepared according to the realisationand accruals conceptsThe gross profit is found by deducting the cost of sales from the turnoverThe operating profit is found by deducting expenses(excluding interest) from the grossprThe net profit before tax and interest is found by adding finance ineThe net profit before tax is found by deducting finance costsThe net profit after tax is found by deducting taxThe earnings of the ordinary shareholders, ie the profit attributable to equity holders, isthe net profit after tax less preference dividends (if any)The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 32CT2-08: The main accountsThe cashflow statementCashflow statements show where the money has e from and where it has gone. Theaccruals concept is ignoredThere are three sections to the cashflow statementcashflows from operating activitiescashflows from investing activitiescashflows from financing activitiStatement of changes in equityThe statement of changes in equity shows how the position of equity(share capitalother reserves and retained earnings)has changed over the year.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsChapter 8 SolutionsSolution 8.1a recording pany might have the following intangible assetsthe recording artists it has signed and paid for, who are contracted to sell theiralbums through that pany, would be classed as intangible assetsany marketing pany it may have purchased in the past would have beenbought at well above book value (advertising panies tend to be largelyhuman capital, and sell at well above their net asset value). This would be heldon the balance sheet as an intangibleSolution 8. 2Most financial assets, eg shares in other panies or property, are recorded atvalue(broadly market value). This is because the cost concept could give unreasonablyunrealistic values. Redeemable fixed-interest assets may be valued at amortised costie its value may be changed in line with the time to expiry.Solution 8. 3Cash CA, Trade receivable CA, Building NA, Tax due CL, Trade payable CL, Land NAInventories CA, Dividend CL, Ordinary Shares C, Debenture NLThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accountsSolution 8. 4Balance sheet for AbC plc at 31st December 2007£O00sASSETSNon-current assetsMachiAccumulated depreciation132215LandCurrent assetsInventories135CashTotal assets951EQUITY AND LIABILITIESOrdinary share capital200Other reservesRetained earningsTotal equity485Non-current liabilitiesLong-term borrowings289Current liabilitiespayableTax provision67Total liabilities466Total equity and liabilities951C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsSolution 8 5The cost of sales is only the cost of stock sold. This is found as followsOpening stock£2.000Purchases£20.000Closing sto(£7,000Cost of sales£15.00The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accountsSolution 8Ine statement for xYZ plc for the year ending 31st December 2007Reven1,135Cost of salesCost of stock soldPurchaseless closing stock(38)287Wages and salaries of production staff161Depreciation of machineryGross profit662Distribution costsAdvertisiages of distribution staffAdministrative expensesWages of administrative staffDirectors remuneration135Operating profit159Finance ineFinance costNet profit before tax150Profit for the year attributable to equity107holders of the panyEaprofit attributableequity holdersa dividend of t30,000, ie 15p per ordinary share, was paid during the year in respect ofthe year ending 3 1 December 2006C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsPage 37notes to the accounts:The pany proposes to make a dividend payment of t35, 667, ie 178p perordinary share, in respect of the year ending 31 December 2007Solution 8.7The following is only one of a number of possible examplesLet us assume that a pany pays a fee of $10 million to a marketing pany toadvertise its product over the ing 12 months. Let us also assume that the panysaccounting year runs from Ist January to 3 lst December, and that the date of the deal isIst JulyThe payment of the fee is clearly a distribution cost and should be shown as such in theine statement. The payment of the fee would have an immediate cashflow effectwhich would fall into the cashflow statement in the current financial year. However, bhe accruals principle, the expense should be recognised over the period of the contractie over the period which the pany expects to benefit from the expenditure. It willtherefore be accrued over the ing 12 months, and $5 million will fall into this yearsine statement and $5 million into the next financial yearSo cash will fall by $10 million, but the ine statement for the year will show anexpense of $5 millionThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accountsSolution 88EventPre-tax profits Casha the purchase of a non-current asset for cash No changeReducedb selling goods on creditHigherNo changec purchasing raw materials on creditNo changed increasing the depreciation chargeLowerNo changee an upward revaluation of inventories held HigherNo changef issue of loan capital or new shares for cash No changeg selling an investment(capital gain=O)No changeh being assessed for, and paying taxNo changeLowerpaying dividendsNo changepaying a creditorNo changeLowerComment: cash and profits are not the sameC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsSolution 8 9The main problem is that profits are directly influenced by the value placed oninventories(stocks) and depreciation, yet the assessment of these is, to an extent,(1) valuation of inventories(stocks)Increase in inventories is included within a pany's ine statement, so alarge increase in inventories over a particular year may lead to an increase inprofits even though sales revenue has not increasedIf inventories are valued on a fifo basis their value will increase with inflationThe distortion mentioned above will be enhanced by this factorNote: A FIFo basis indicates the method by which a pany calculates its costof materials. If a certain amount of stock is disposed of as a result of selling thepanys product, then the pany can either take the cost of that stock asbeing the cost of the most recently purchased stock (Last In First Out)or the costof the oldest stock(First In First Out). Best accounting practice suggests the useof FiFoDoes the method of inventory valuation really give a true and realisable value ofthe inventories held at any one point in time? If it does not, then any figure forincrease in inventories shown in an ine statement may be questionable( ii) Assessment of depreciationThe assumptions made about an asset may not be true to life, eg a lorry with anexpected useful life of ten years may, in reality, need to be replaced after sevenyears. The depreciation charge during the 7 years would then not reflect the truecost of using the assetThe method of calculation may not be appropriate to the asset. For examplemany panies use the straight line method of depreciation for their vehiclesbecause they would expect the vehicles to be used at a reasonably constant rateHowever, as any car owner will know, this type of depreciation is not necessarilythe most appropriate. A new car can depreciate fastest during the first 5 minutesfter its purchaseThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-08: The main accountsSolution 8.10Cashflow statement for LoadsaMoney 2007Cashflows from operating activitiesCash generated from operations187700Interest paid(5,500)Tax paidNet cash generated from operating activities133.080Cashfows from investing activitPurchases of machinery(105,000Interest received3.500Dividends received4.20Net cash used in investing activities(97,300Cashflows from financing activitiesEquity dividends paidNet cash used in financing activities(15,000)Net increase in cash/cash equivalents and bank overdraft20.780Cash/cash equivalents and bank overdrafts at beginning of the year148.000Cash/cash equivalents and bank overdrafts at end of the year168,780Cash generated from operations isOperating profit191.850plus Depreciation22.450less Increase in inventories(stocks)(13,500+2,100(15,600less Increase in trade receivables(debtors)(71,000-63,000)(8,000less Decrease in trade payables(creditors) ( 37,000-40,000)3.000Cash generated from operations187.700C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-08: The main accountsPage 41Solution 8 11Statement of changes in equity for 2007Attributable to equity holde£O00sShareOther RetainedTotalcapitalearnIngsequityBalance at 3/ December 20068002005001,500Fair value gains on land and100100buildinProfit for 2007120120Total recognised ine for 2007100120220(20)Issue of share capital during 2007 200Balance at 31 December 2007,0004006002,.000The Actuarial Education CompanyC IFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-09: Depreciation and reservesPage 1Chapter 9Depreciation and reservesSyllabus objectives(viii) Describe the basic construction of accounts of different types and the role andprincipal features of the accounts of a pany9Explain how depreciation is treated in panmy accountsExplain the function of the following accountsshare capitalother reservesretained earnings0 IntroductionThis is a short chapter containing a more detailed discussion of depreciation andreservesThe examination is likely to test your understanding of the purpose of depreciation and thenature of reserves, your ability to calculate depreciation and reserves, and your ability toevaluate a panys policy on depreciation or reservesThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 2CT2-09: Depreciation and reserves1 Depreciation1.1 What is the purpose of depreciationDepreciation adjustments are required because virtually all non-current assetshave finite useful economic lives. land is an exception and is usually revalued ratherthan depreciated over timevalue of non-current assets purchased during the year. There are two reasons forth s theThe ine statement needs to show the cost of using non-current assets -notIf a pany buys an asset which it still owns at the end of the year, thepany has not lost the whole amount spent. The real loss is the differencebetween the value of the asset at the start of the year (or the cash the panyused for its purchase)and the value of the asset at the end of the year2. The amount spent on non-current assets can vary considerably from year to yearThe ine statement would not therefore give a true picture of a panysunderlying long-term profitability if expenditure on non-current assets wasallowed to distort profits from year to yearSo instead of showing expenditure on non-current assets, panies show the amountby which their assets have depreciated over the year. Depreciation measures the amountof the capital stock that has been used up during the yearDepreciation is defined as the measure of the wearing out, consumption or otherreduction in the useful economic life of a non-current asset, whether arisingeffluxion(passage)of time, orobsolescence through technological or market changesThe first, and most important, aspect of this definition is that depreciationadjustments are not attempts to reflect the value of non- current assets in thebalance sheet. Rather, the purpose is to charge the purchase price of thepany's non-current assets in the ine statement in a systematic way.Depreciation is, therefore, an application of the matching concept referred toearlier in Chapter 7.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-09: Depreciation and reservesPage 3The definition of depreciation also makes it reasonably clear that the manner inwhich an assets life diminishes varies according to the nature of the assetA financial asset, such as a lease on some property, has a life span whichis fixed in terms of timePhysical assets are likely to wear out through use and are likely todeteriorate more rapidly when they are used more heavilySome assets, such as puters, are more likely to be overtaken by newtechnology long before the end of their physical livesIdeally, these differences should be reflected by having different bases fordepreciation which reflect the nature of the assets. In practice, the cost ofof usage and output that the charge is usually based on the passage of time ingcalculating depreciation in this way would involve such detailed record keeThus, a new asset might be purchased for say E1,000. Management mightestimate that it will have a useful life of five years (or that normal wear and tearwill bring it to the end of its useful physical life in five years'time), at which timeit will be sold for scrap for, say, E100. This raises the question of the mostappropriate way to spread that e900 loss of value over the next five inestatementsThe simplest method is called the straight line basis1.2 The straight line basisThis charges equal amounts every year as follows:Cost- Estimated residual valueEstimated useful lifeThat would give a charge of1.000-100E180 per annumThe straight line basis can also be expressed by charging a percentage of costIf it was assumed that the estimated residual value was immaterial then thecharge could be calculated as 20% of cost per annum, where the cost is theoriginal cost of the assetThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 4CT2-09: Depreciation and reservesIntangible assets may also suffer depreciation. Depreciation of intangible assets can bedepreciation of tangible assets. For examplpanys purchase of the right to use the name Waterloo Bears for the next 20 years ata cost of t60,000 will suffer depreciation of f3,000 cach year(ie based on the straightline method of depreciation with no residual value)1.3 The reducing balance methodThe reducing balance method is the other mon method of chargingdepreciation. This charges a fixed percentage of"book value"(e cost lessdepreciation to date)so that the whole cost is charged over the life of the assetThe depreciation rate is calculated as followsEstimated residual valueCostwhere n is the estimated useful life in yearsThus, the rate to be applied to our example would be100100037%(rounded and expressed as a percentage)The depreciation charged for a particular year under this method will be the value of theasset at the beginning of the year multiplied by the rate of depreciation. The charge tothe ine statement of depreciation on a particular non-current asset will therefore falleach year under the reducing balance methodhat means that the first years depreciation will be E1,000 X 37%= E370, leavinga book value of E630. the second years depreciation will be E630 x 37%= E233and so onotice that the depreciation rate is the effective rate of discount, which you might havestudied in Subject CTC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-09: Depreciation and reservesPage 5Over the life of the asset, the following pattern would emerge:Book value at startBook value atYearof year Depreciation end of year1,00037063023339739714725025092558100Question 9.1Consider the following non-current assetsfactory, initial cost f250,000, estimated useful life 25 years, no residual valuetwo vans, initial cost f15,000 each, estimated useful life 6 years, no residualvaluemachinery, initial cost E122, 000, estimated useful life 11 years, estimatedresidual value f13.750The factory was bought 7 years ago. The vans and the machinery were all bought at thebeginning of 2007The factory and the vans are depreciated using the straight line method. Depreciation onthe machinery is worked out using the reducing balance methodCalculate the pany's total depreciation charge for 2007One advantage of the reducing balance method is that it tends to charge aheavier proportion of the cost of the assets when they are new. This mightmake the depreciation charge in the ine statement more relevant becausemost of the charge will be based on the cost of newer, more recent assets. Thestraight line method weights assets equally, regardless of their age, which canbe a drawback when the cost of assets is rising because of inflationIn practice, it is mon for panies to assume that all assets of a particularclass will last a"standard"'life(eg four years for vehicles and ten years formanufacturing plant). These rates will be based on experience and will reflectthe general patterns observed by that pany. The errors which creep inbecause some assets are depreciated too slowly will tend to cancel those whicharise because others are depreciated too rapidly.The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 6CT2-09: Depreciation and reservesClearly, management has a considerable amount of discretion over the amountto be charged for depreciation in any given year The estimates of useful life andresidual value will affect both the ine statement charge and the balancesheet valuation. The selection of either straight line or reducing balancedepreciation will also have an impactA pany cannot however change its depreciation policy from year to year withoutgood cause. Companies also disclose a great deal of information concerning theirdepreciation policies which gives the reader a lot of information about the non-currentassets and their book values over the accounting periodThus, panies are required to provide a considerable amount of detail abouttheir non-current asset balancesFreehold LeaseholdLand and Land and Plant andbuildings buildings MachineryTotal£000£000£000£000Cost or Valuation1 January 200X200100350Additions1016Dals(7)(6)(8)(21)31 December 200X2039646345Depreciation1 January 200x01666Charge for yearDisposals31 December 200X26Net book value31 December 200X17270292711 January 200X17080284C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-09: Depreciation and reservesPage 7Question 9.2Why do disposals represent a negative in the depreciation calculation table above?This information would be supplemented by a detailed statement of theaccounting policies used in deriving the figures. Anyone reading this note willtherefore, be able to make some rough estimates of the effects of using aparticular accounting policy and might, therefore, be able to change the figuresto make them parable with those of another pany. It also permits somecrude estimates of the proportion of the assets useful lives which have beenconsumed to date. That might make it possible to predict major events such asthe issue of fresh share capital or the raising of a loan with which to invest innon-current assetsQuestion 9.3You are examining a pany's balance sheets for two years in order to understandwhat has happened to the non-current assets over the period. Given the selected itemsfrom the balance sheets and additional data. calculate the amount received from the saleof non-current assets31 July 200731Jlty2006£000s£O00sNon-current assets3,9763.465Depreciation1.0332,7312,432Additional informationDuring the year, the pany paid t900,000 for new equipmentThe depreciation allowance for the year is #432,000The pany made a loss on the disposal of non-current assets of f50,000The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 8CT2-09: Depreciation and reserves2 Capital and reservesThe balance sheet lists the assets owned by the pany and the liabilitieswhich are owed to third parties. the residual amount is called capital or equityand belongs to the shareholdersEquity can arise in three main waysby the sale of shares to the shareholdersby certain adjustments, such as the revaluation of non-current assetsby the retention of profit after tax2.1 Share capital and share premiumQuestion 9.4How would you calculate the nominal value of a panys issued share capital?Shares carry a"nominal"value for bookkeeping purposes. This does nothowever, necessarily reflect the market value of the pany and it is possiblethat the pany will be able to find buyers who would be willing to pay ratherOrdinary shares are always issued at or above their par value. Any excess money raisedover their nominal value is shown under the heading "share premium account", which ispart of"other reservesFor example, when it was formed, a US pany issued half a million fully paid $0. 25shares at a price of S0. 37 each. The nominal amount of $125,000($0. 25 x 500,000)isshown under the heading"called up share capital"and the extra $60,000 raised(S0. 12 X500,000)under the heading"share premium accountThe difference between the nominal value of the shares and their selling price iscalled the share premium account". It is not permissible to issue shares at adiscountC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-09: Depreciation and reservesPage 9The share premium account can also be used forthe preliminary expenses of forming a panythe expenses and missions incurred in any issue of sharesany profit or loss on the issue of loan stockany premium paid on the redemption of loan stockthe expenses of issue of loan stockThese items will be added/ charged to the share premium account as and when necessaryEffectively, the share premium account is just a part of the pany,'s sharecapital, but its value is included in"Other reserves" in the balance sheet formatused in Chapter 8. It shows the excess of shareholder investment over the nominalvalue of the shares2.2 Revaluation reserveDespite the cost concept, it is mon practice to revalue land and buildings inthe balance sheetIf, for example, the pany owned a factory which had cost E300,000 and hadbeen depreciated by E70,000 it would be valued at a net book value of f230,000in the balance sheet. If the pany's advisers valued the property at, say,E400,000 then this could be reflected in the financial statements by restating thedepreciation to date as zero and replacing the cost" of 300,000 with avaluation "of E400, 000.Simply increasing the balance sheet value of assets by E170,000 would throwthe balance sheet out of balance. This is rectified by increasing the"revaluationreserveby£170,000The annual depreciation is then based upon the revalued amount. The valuationwill be written off over the estimated useful life of the asset. It is acceptable forthe pany to revise its expectations as to the expected useful life at the timeof the revaluationThe amount of the revaluation reserve is included in "other reserves'in thebalance sheet format used in Chapter 8.Alternatively, as mentioned in Chapters 7 and 8, the move towards" fair valueaccounting, has led to the recognising of revaluations in the ine statementand this has proved controversialThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 10CT2-09: Depreciation and reservesQuestion 9.5Should this revaluation lead to a reported profit?The following example shows revaluation through the revaluation reserveTo illustrate the effect of revaluation, assume that the pany which owned thefactory had no other assets. Its balance sheet entries before and after therevaluation might be made up as follows31 December 200x 31 December 200Xbefore revaluation after revaluationNon-current assetsFactory(cost)300,000400,000Factory(depreciation)(70,000)230.000400,000Total assets230.000400.000Share capital25,00025,000Other reservesShare premium15,00015000Revaluation reserve170.000Retained earnings90.00090.000Total equity130.000300.000Non-current liabilitiesLong-term borrowings100000100,000Total non-current liabilities100.000100.000Total liabilities100,000Total equity and liabilities230,000400.000The second balance sheet certainly appears much stronger. Assets are nowfour times greater than non-current liabilities instead of just over twice as greatEquity has more than doubled. And yet all that has happened is that thepany has decided to restate the basis for the valuation of its assetsQuestion 9. 6What is the case for and against fair value accounting for all assets and liabilities, ie theannual revaluation of assets and liabilities in a balance sheet and the recording of anygains or losses in the ine statement?C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-09: Depreciation and reservesetained earningsThe balance on the retained earnings reserve is normally the aggregate amountof profits earned during the lifetime of the pany, less amounts paid out ofprofits for tax and dividends.Normally the balance on the retained earnings reserve provides all of thepany's distributable reserves. Company law restricts dividends by linkingthe maximum payout to distributable reserves in order to protect the interests ofcreditors. otherwise the directors could use all of a failing pany 'sremaining assets to pay a massive dividend to its shareholders. Doing so wouldact against the interests of the pany,'s creditors and lendersIn the preceding example, the maximum dividend payment would be E90,000 andthis is not affected by the fact that equity increases as a result of the revaluationThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 12CT2-09: Depreciation and reservesQuestion 9.7Goright plc is in the process of preparing its balance sheet for 31st December 2007. Sofar, the items(valued at 3 lst December 2007 unless otherwise stated) are£O00sNon-current assets at cost547Accumulated depreciation (3 lst December 2006)50Current assets165Long-term loansShare capitalShare premium50Revaluation reserveRetained earnings (31st December 2006)For the year to 3 1st December 2007the depreciation figure in the ine statement is f12, 000the profit after tax is f30,000ne directors distributed half of the pany's earnings to its shareholders in theform of a dividendThe pany's accountants take the view that the panys non-current assets shouldbe revalued at t600.000Prepare the balance sheet for Goright plc at 3 lst December 2007(1) without revaluation of the non-current assets(ii with revaluation of the non-current assetsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-09: Depreciation and reservesChapter 9 SummaryDepreciationDepreciation shows the cost of using non-current assets. It measures the amount ofcapital stock that has been used up over the year due to wear and tear, passage of time orobsolescence. The value of the assets may be written off evenly over a number of yearsusing the straight line method. Alternatively a constant rate of depreciation may beused, using the reducing balance method.Share capital and reservesThere are three main items in the share capital and reservesShare capital is the nominal value of the shares issuedOther reserves include(a) the share premium account, which records the additional amount raisedfrom the share issue in excess of the nominal value(b) the revaluation reserve, which records the increase in the value of noncurrent assets if non-current assets are revalued upwardsRetained earnings records the profit retained in the business to dateThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 14CT2-09: Depreciation and reservesThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-09: Depreciation and reservesChapter 9 SolutionsSolution 9. 1Factoryannual depreciation charge (using the straight line method)50,000=10.000ansannual depreciation charge(using the straight line method2×15,000Machinery: using the reducing balance method, we first need to calculate the rate ofdepreciation r122.00×(113.7500.18=0.18×122.00021,960Thus, total depreciation charge for the year=10,000+5,000+21,960=£36,960The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-09: Depreciation and reservesSolution 9. 2A non-current asset that has been in the panys books for some time will be valuedat cost(ie the full purchase cost) less some amount of depreciation. When that asset issold, the full purchase cost of the asset is deducted from the non-current asset accountand the amount of the depreciation to date-of-sale is deducted from the depreciationaccount-ie negative depreciationSolution 9. 3For the assets that were sold we need to find out their book value. firstly, find out theirvalue at costThe non-current assets at cost were 53, 465,000 in 2006 and 53, 976,000 in 2007. duringthis year, f900,000 was spent on non-current assets and an unknown value of nonurrent assets at cost(x)were disposed of. Thus£3,465,000+f900,000-x=£3,976,000x=£389.000Secondly, find the depreciation attached to the assets that were soldThe accumulated depreciation to the 3 lst July 2006 was f1,033,000, and theaccumulated depreciation to the 3lst July 2007 was f1, 245,000. during the year, thepany's assets depreciated by t432,000, but some assets with accumulateddepreciation attached to them (y) were sold. Thus£1,033,000+£432,000-y=£1,245,000y=£220,000Thirdly find the book value of the assets that were sold. This amounts ty=£389,000-£220,000=f169,000Finally, we find the amount received from the sale of these assetsWe are told that these assets were sold at a loss of t50.000. Thus the assets were soldat f50,000 less than their book value, ie they were sold at E119, 000C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-09: Depreciation and reservesPage 17Solution 9. 4The nominal amount of issued share capitalnumber of shares issued x par value of sharesSolution 9.5PerhapsIf the depreciation of non-current assets each year has led to a reduction of profit in thepast, then it could be argued that the opposite action of revaluing assets should betreated consistently, particularly if the new higher value of the asset is going to lead tohigher depreciation in the future, and consequently lower profits. An argument can bemade that such a revaluation should be disclosed in the pany' s ine statementIAS 39, relating to financial instruments, says that if a pany holds financialinstruments for trading purposes, these should be recorded at fair values, and any changein fair values should be taken through the ine statement. Also, IAs 40 relating toinvestment property says that if a pany chooses to show investment property at fairvalue, then the increase in fair value should be recognised immediately in the inestatementHowever, the move towards recognising gains in the ine statement has provedcontroversial. It causes great volatility in reported profit; it makes it difficult to interpretthe profit figure; and it seems imprudent to record unrealised profitSolution 9. 6ase forReaders of accounting information may want to know the current market valueof the pany's assets and liabilitiesMore realistic valuation of the panys capital will give a more realistic rateof return on capitalFair values are a better basis for decision making than historical costs. Theyoffer a more realistic view of the net worth of the business this would be usefulwhen selling assets, merging or being taken overCompany would, by increased allowance for depreciation, be conservingadequate funds for the replacement of the assetsThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-09: Depreciation and reservesCompany could obtain more loan finance on the basis of the increased value ofits assetsIf a pany's assets have fallen in value, this indicates poor stewardship of thepany 's assets and should be reflected in the ine statementCase againstFair values are not a better basis for decision making unless all balance sheetitems are measured at fair values. At the moment some measurements are madeat fair value and others at historical costFair values increase the risk of misunderstanding on the part of existing orpotential investors. Although the fair value of an asset is broadly its marketalue, the net fair value of the balance sheet willmarket value of the pany because of internally generated goodwill in theform of intangible assets, such as the value of the customer basef the ine statement. Changes in marketvalues will change the ine statement so it will be difficult to judge theeasons for a change in the performance of a pany. Is an increase in profitprofit clearer. (The IASB is considering a two-statement approach to the inestatement.)Ine will bee more volatileProfits arising from increases in value of assets may not have been realisedRecognition of unrealised capital gains goes against the traditional prudentapproach to accountingProperly qualified regulated professionals will be required to undertake therevaluation if fair values are to be relied onHow reliable is the data on fair values? where there is a well-defined marketthe asset, this is not a problem, but for illiquid assets and liabilities it may benecessary to use a model, such as one based on the present value of futureine. The models used, and the assumptions made within those models, willdiffer across panies, causing problems for auditorsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-09: Depreciation and reservesSolution 9.7(i) Without revaluation of the non-current assetsBalance sheet for Goright plc at 3lst December 2007Non-current assets47Depreciation(62)Current assetsTotal assets650Share capital and reservesShare capital300Other reservesShare premium50Revaluation reserve30Retained earningsLong-term loans200Total equity and liabilitiesThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-09: Depreciation and reserves(i With revaluation of the non-current assetsBalance sheet for Goright plc at 3 1st December 2007£000Non-currssetsCost600Depreciation0600Current assets165Total assets765Share capital and reserves300Other reservesShare premiumRevaluation reserveRetained earningsLong-term loansTotal equity and liabilities765C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-10: Generating accountsPage 1Chapter 10Generating accountsSyllabus objectives(viii) Describe the basic construction of accounts of different types and the role andprincipal features of the accounts of a pany4Construct simple balance sheets, ine statements and cashflow statements0 IntroductionIn Chapter 8, we studied the structure of the main accounts. In this chapter, we aregoing to learn how to construct the balance sheet and the ine statement frominformation contained in the trial balanceOnce you have read and understood how to pile a set of accounts, you need to practisedrawing up a set of accounts for yourself. There is an exam-style question at the end ofthe chapter and there are lots more questions in the Question and Answer BankThe examination is likely to test your ability to construct the main accountsThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 2CT2-10: Generating accounts1 The trial balance1.1 Description of the trial balanceThe double-entry system of bookkeeping is used to create a number of balancingaccounts. These accounts are held together in a ledger, and all of the accounts can beused to create a trial balance. The trial balance is simply a list of all the accounts in theledger and the balances in each accountThe trial balance leads directly to the production of a balance sheet and an inestatementYou will not be required to construct a trial balance but you do have to know how to usea trial balance to construct a balance sheet and an ine statementThe trial balance can be presented in a number of waysas a simple list of numbers2. as a list of positive and negative numbers adding to zero3. as two columns(debits and credits) giving the same totalIf it is presented as a list of numbers, you are given no clue as to whether the accountsare debits or credits. If it is presented as a list of numbers adding to zero, the credititems are positive and the debit items are negative. The credit items consist of revenfor the ine statement)and liabilities and capital (for the balance sheet); and thedebit items consist of expenses(for the ine statement) and assets(for the balanceAs an example, assume that the following balances have been extracted fromthe books of JK plc, as at 31 March 200XC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-10: Generating accountsPage 3£000Administrative expenses150AdvertisingCash at bankTrade payables(creditors)Trade receivables(Debtors)115Directors'remuneration75Interest on long-term loansnvestment ineInvestments(short-term)350Longterm loansOrdinary dividend paid (see note 8 below)Ordinary share capital, issued and fully paid700Plant and machinery-cost210Plant and machinery-depreciation at 31 March 200X-1Premises-cost950Premises -depreciation at 31 March 200x-1PurchasesRetained earnings at 31 March 200X -1236Sales(revenue)1,760Shareholder reserves50Stock at 31 March 200X-1130Wages and salaries- administrative staff160Wages and salaries-manufacturing staff190Wages and salaries- sales staftAdditional informationStock at 31 March 200X was valued at E185.000Provision is to be made for administrative expenses owing at 31 March200X amounting to E12, 000.3. Premises are to be depreciated at the rate of 2% on cost, and plant andmachinery at 25% reducing balance4. Advertising paid in advance at the end of the year amounted to E9, 000Corporation tax based on the year' s profit is estimated at E15,0006The pany's ordinary share capital is 700,000 E1 ordinary shares, fullyp7. A final ordinary dividend of 5p per share is proposed see note onpage 88. The ordinary dividends paid are the dividends for the year 200X-1The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 4CT2-10: Generating accountsThe trial balance above has been presented as a list of numbers. This could be rewrittenas two columns(debits and credits) giving the same total as followsDebits CreditsAdministrative expenses150AdvertisingCash at bankTrade payables( creditors)Trade receivables(Debtors)Directors ' remunerationInterest on long-term loansInⅴ estment ineInvestments(short-term)350Long-term loansOrdinary dividend for 200X-I paidOrdinary share capital, issued and fully paid700Plant and machinery -cost210Plant and machinery -depreciation at 3 1 March 200X-lPremises -cost950Premises-depreciation at 3 1 March 200X-l20Retained earnings at 3 1 March 200X-I236Purchases600Sales(revenue)1.760Shareholder reserves50Stock at 3 1 March 200X-1130salaries- administrative staff160Wages and salaries-manufacturing staff190Wages and salaries- sales staff3,1243,124It is useful to have an understanding of debits and credits because sometimes it isdifficult to know how to treat particular items in the trial balance. For example, iflisted in a trial balance. hould it be treated? without furthinformation you would not know whether this"interest referred to interest ing in(ie investment ine) or interest going out(ie interest payments). By reference to thcolumn in which the item is placed, you will be able to tell. If it is in the debit column(with all the other expense items ), it must be"interest paid"; if it is in the credit column(with sales revenue), it must be"interest receivedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-10: Generating accountsPage 5If you are presented with a simple list of items in the trial balance and you are not surehow to treat an item, you could rewrite it as two columns and check that the two columnadd to the same number1.2 Awkward items in the trial balanceDepreciationNon-current assets pose a slight problem. This is because of an issue calleddepreciation which was discussed in Chapter 9. For now, it is worth noting thatit is the net figure which is shown in the balance sheet for each category of noncurrent assets. Thus, the value of premises is E950, 000-E20,000= E930, 000Notice that when the trial balance is presented as a list of credits and debits, the fixedasset at cost is recorded as a debit item and theiation is recorded as a credit iteYou can think of the depreciation as an item that reduces the value of the non-currentassets: it is the net figure that is importantNotice that the trial balance does not contain information on this years depreciationThus, the book value of the premises at the beginning of this accounting yearE930,000. This years depreciation is given in a note at the bottom of the trial balanceYou will need this year's depreciation for the ine statement and you will also need itto find the book value of the non-current assets at the end of the accounting year for thebalance sheetRetained earningsNotice that the retained earnings reserve is for the beginning of the accounting yearThe accounts are updated in the trial balance when the ine statement is drawn upThe retained profit for the period is added to the retained earnings reserve in order toplete the balance sheet. If the trial balance were to be re-drawn after the inestatement had been pleted it would show a retained earnings reserve at 3 1st March200X and all of the revenue/expense items such as sales and administration expenseswould be set to zeroThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 6CT2-10: Generating accountsInventories (Stock)Notice that the figure for inventories at the beginning of the accounting year(ie operstock) is included in the trial balance. Stock is a current asset of the business, but theopening stock is not used in the end of year balance sheet. The figure for closing stockis noted below the trial balance. This figure is needed for the end of year balance sheetBoth opening stock and closing stock are needed, along with purchases of new stock, tofind the cost of stock sold for the ine statementAdjustments for the accruals concepiRemember that the ine statement records cost items when they are incurred(even ifthe pany has not yet paid for them or has paid for them in advance). Notes will bemade at the bottom of the trial balance to take account of any adjustments necessaryFor example, if corporation tax is incurred in this accounting year, it should be in thisyear's ine statement, even if it has not yet been paid. It will be recorded as a currentliability in the balance sheet if it has not been paidDividendsAny question on this topic should make it clear whether the dividend paid in the trialbalance relates to the current year or to the previous year. Dividends paid will be shownas a note at the bottom of the ine statement disclosed in the notes to the accountsind will affect the statement of changes in equity and cashflow statementC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-10: Generating accountsPage 72 Constructing financial statementsThe preparation of a set of financial statements can be an extremely plexaffair. Degree courses in accountancy would devote at least one class everyyear to this topic and it would then be a major ponent of the professionalcourses taken by accountants after graduation This section is, thereforeintended to give only a brief overview of the mechanics of preparing an inestatement balance sheet and cashflow statement2.1 Preparing the ine statement and the balance sheetThese statements are prepared from the underlying bookkeeping records. Alltransactions are recorded during the year and are entered into a double entrybookkeeping system. This generates a table called a trial balanceas we have seen. the trial balance consists of accounts that are needed for the inestatement(ie revenue and expenses) and accounts that are needed for the balance sheet(ie assets, liabilities and capital)Every figure in the trial balance is used once in the preparation of either theine statement or the balance sheetQuestion 10. 1Label each of the accounts listed in the trial balance on page 3(1 as capital(C), liability (L), asset(A), revenue(R)or expense(E)account(ii) as an entry in the balance sheet(B )or in the ine statement ( IThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 8CT2-10: Generating accountsThe ine statement (set out in the same format as in chapter 8, Section 2would be prepared by extracting the ine and expense figures andrearranging them as followsJK plcIne statement for the year ended 31 March 200X£000RevenueCost of sales(783)Gs pfi977Distribution costsAdministrative expenses397)Operating profit439Finance ine18Finance costsNet profit before tax453Tax expenseProfit after tax438Profit for the year attributable to equity holders of the pany438Earnings per share for profit attributable to equity holderspenceduring the year with the payments totalling $30, 0 ers of ordinary share capitalA dividend of 4.3p per share was paid to the holdeFor accounting periods starting on or after 1 January 2005, dividends proposedwould be disclosed in a note to the accountsThe dividends paid would be disclosed under the ine statement(as above)in the statement of changes in equity, in the cashflow statement and in the notesto the accountsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-10: Generating accountsPage 9In order to prepare these reported figures, supplementary working needs to bedone. as followsWorkings£000Cost of salesOpening stock130Closing stock(185)Depreciation- premisesDepreciation- plant and machineryWages and salaries783Distribution costsAdvertisingLess- prepaidWages and salaries141Administrative expensesAdministrative expenses150Add- accrual12Directors'remunerationWages and salaries160397The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-10: Generating accountsThe remainder of the figures are reorganised to give a balance sheet (set out inthe same format as in Chapter 8, Section 1)JK plcBalance sheet at 31 March 200X£000SSETSNon-current assets997Current assetsInventories185Trade receivables115Other current assets359Cash10Total assets1666EQUITY AND LIABILITIESShare capitalother reservesRetained earnings644Total equit1,394Non-current liabilitiesLong-term borrowings200Total non-current liabilities200Current liabilitiesTrade and other payables57Current tax payable15Total current liabilities72Total liabilities272Total equity and liabilities1,666C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-10: Generating accountsIn order to prepare these reported figures, supplementary working needs to bedone. as followsWorkings£000sNon-current assetsCost Aggregate Net bookdepreciationvaluePremises950Plant and machine2101241,160163997Other current assetsInvestments(short-term)350Pre-paid expense9359Retained earningsRetained earnings at 31 March 200X -1236Retained earnings for year to 31 March 200X 438Dividends paidNote: The proposed dividend for the year would be disclosed in a note to theaccounts. The amount paid will be shown in next year' s statement as set out inChapter 8, Section 2.7.Trade and other payablesTrade payables(Creditors)Administrative expensesThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 12CT2-10: Generating accounts2.2 Preparing the cashflow statementThe cashflow statement reports the cash paid during the accounting period fornon-current assets, raw materials, wages, etc (rather than matching theconsumption of those resources to the sales generated)and the cash receivedfrom customers (rather than the sales made). It also includes cash receivedfrom owners and lendersThe cashflow statement, therefore, will not include credit sales(and bad debts)or any accrual of expenses. However, prepayments will be included in full.Taxation shown will reflect the tax paid on previous periods profits, rather thanthe tax due in respect of the current period. Inventories, depreciation, tradeayables and trade receivables will not appear.In order to prepare a cashflow statement, you will needdetails of all cash transactions that have taken place over the yearthe start and end-year balance sheets and the ine statement for the yearAn example of a cashflow statement was given in Chapter 8, Section 32. 3 Preparing the statement of changes in equityThe statement of changes in equity summarises the changes in the capital andreserves attributable to equity holders of the pany over the accountingpeIn order to prepare a statement of changes in equity, you will need the equity section ofthe start and end-year balance sheets, with detailed notesAn example was given in Chapter 8, Section 4.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-10: Generating accountsQuestion 10.2Define the following terms(1) trial balance(ii) cashflow statement(iii balance sheetIne statement(v) statement of changes in equityThe following question is typical of the trial balance questions asked in previousexaminationsRead the question very carefully. Since each item on the trial balance is used only once,in either the ine statement or the balance sheet you could make a note by the side ofeach item(l or B), and tick off each item as it is usedRead the notes below the trial balance carefully and work out the impact of each note onthe accounts. Each note will have two effects on the accountsThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 14CT2-10: Generating accountsQuestion 10.3The following information has been extracted from the accounting records of Aztec plcTrial Balance at 3 1 July 2007£O00Administration cost800Marketing expenses500Bank700Trade receivables(debtorsFactory-costF1,800FDirectors remuneration600Interim dividend paidLong-term loans12.000Machinery-cost15.000Machinery-depreciation8,000Manufacturing wagesPurchases1.600Retained earnings at 31 July 2006980Sales salariesShare capital (50p shares)13,000Inventories at 3 1 July 2006700Trade payables(creditors)60050,0800,080(a) The corporation tax charge for the year has been estimated at f300,000(b) The directors have proposed a final dividend of E500,000(c) At the year-end the directors had the factory professionally revalued. Thevaluer's report estimates the value of the property at t25, 000,000. This value isto be incorporated into the balance sheetd) Depreciation for the year is charged at 1%of cost for the factory and at 20% ofthe reducing balance for the machinery.(e) Inventories at 3 1st July 2007 were valued at E550,000(f) After the year-end, an invoice for E100,000 was received for marketing costsincurred in the period 1 April -31st July 2007.Prepare Aztec plc's ine statement for the year ended 31 July 2007 and the balancesheet as at that dateC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-10: Generating accountsEnd of part 2You have now pleted Part 2 of the Subject CT2 NotesReviewthe key areas of Part 2, or maybe re-read the summaries at the end of Chapters 7 to 10Before looking at the Question and Answer Bank we remend that you briefly revieQuestion and Answer bankYou should now be able to answer the questions in Part 2 of the Question and AnsweBank. We remend that you work through several of these questions now and savethe remainder for use as part of your revisionAssignmentsOn pleting this part, you should be able to attempt the questions in Assignment X2RemindIf you have not been attending regular tutorials then you mayplace on a block tutorialThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-10: Generating accountsThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-10: Generating accountsPage 17Chapter 10 SummaryThe double-entry system of bookkeeping is used to create a number of balancingaccounts, held together in a ledger. The trial balance is simply a list of all the accountsin the ledger and the balances in each account, The ine statement and the balancesheet are derived from the information in the trial balanceDebit items in the trial balance are expense items for the ine statement and assets forthe balance sheet. Credit items in the trial balance are revenue items for the inestatement and capital and liabilities for the balance sheetNotes at the bottom of the trial balance give information onnventories at the end of the year, ie closing stockthis years depreciationadjustments for the accruals conceptEach figure in the trial balance is used once in the preparation of the ine statementand the balance sheetThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-10: Generating accountsThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-10: Generating accountsChapter 10 SolutionsSolution 10.1CLARE B/Administrative expensesAdvertisingCash at bankTrade payables(creditors)EEALABERALCCAAIIBBBTrade receivables(debtors)Directors' remunerationInterest on long-term loansInvestment ineInvestments(short term)Long-term loansOrdinary dividend for 200X-1I paidOrdinary share capital, issued and fully paidPlant and machinePlant and machinery -depreciation at 3 1 March 200X-lBBBBBBBBPremises- costAPremises-depreciation at 31 March 200X-1Retained earnings at 31 March 200X-1PurchasesSalesShareholder reservesStock at 3 1 March 200X-1Wages and salaries-administrative staffWages and salaries - manufacturing staffERC*EEEBIIIIWages and salaries- sales staffDepreciation reduces the value of the non-current assetsOpening stock, together with closing stock and purchases, is used in the ineatement to arrive at a figure for the cost of stock sold(an expense). Closingstock is a current asset and appears in the end of year balance sheetThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-10: Generating accountsSolution 10.2(i) Trial balanceA summary of all the accounts in the ledger, showing the balance on each account() Cashflow statementa summary of all the transactions which lead to movements of physical cash. The resultshould reconcile to the movement in the bank balance over the period(iii) Balance sheetA summary of all the assets, liabilities and capital of the entity, valued according to anappropriate set of accounting policies at a particular time(iv) Ine statementA summary of all the revenue earned and expenses incurred by a pany over a period(v) Statement of changes in equityA summary of changes in the capital and reserves attributable to equity holders over theaccounting periodC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-10: Generating accountsPage 21Solution 10.3The ine statement for Aztec plc for the year ending 31st July 2007Cost of sales(6283Distribution costs(2,200)Administrative expenses(12400Operating profit(1,Net profit befor(300Net profit after ta1.137Profit for the period attributable toequity holders of the panyEPS for profit attributable to equityholdersAn interim dividend of f100,000, ie 0. 4p per share was paid during the yearNotes1. Cost of sales3. Administrative expensesOpening stock700Administrative costs800,600Directors remuneration600less Closing stock(550)Total1,400Factory running costs1.200Manufacturing wages1, 700 4. DividendsDepreciation of factory233The directors propose a finalDepreciation of machinery 1,400dividend of t500.000Total6,2832. Distribution costsMarketingSales salaries1.600Total2.200The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-10: Generating accountsBalance sheet for Aztec plc as at 31 July 2007ASSETSNon-current assets 530,600Current assetsTrade receivables1,300Inventories551.850Total assets32,450EQUITY AND LIABILITIESShare capital13.000Retained earnings2,017Revaluation reserve3,733Total equity18,750Non-current liabilitiesLong-term loans12.000Current liabilitiesCreditorsOverdraft700Marketing bill owingTax provision1.700Total liabilities13,700Total equity and liabilities32450NotesThe non-current assets are calculated as followsFactory (revalued)Machinery(15.000-8,000-1,400)30,6006The retained earnings=980+1,137-100=2,0177. The revaluation reserve is the new value of the factory at the end of the year lessits book value prior to revaluation=25,000-(23,300-1,800-233)=3,733C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsChapter 11Group accounts andinsurance pany accountsSyllabus objectives(viii) Describe the basic construction of accounts of different types and the role andprincipal features of the accounts of a panyUnderstand the structure and content of insurance pany accounts6. Explain what is meant by the terms subsidiary pany and associatedpanyExplain the purpose of consolidated accounts8. Explain how goodwill might arise on the consolidation of group accounts0 IntroductionIn Part 2 you learned about the accounting framework and how accounts are piledIn the first chapter of Part 3 we consider two particular types of accountsFirstly, we look at how accounts are produced by groups of interrelated paniesHere the accounts need to show not only the financial position of each pany withinthe group, but also the picture for the group as a bined economic entity. Notice thatthe syllabus requires yoyou to explain the purpose of consolidated accounts: you are notrequired to construct consolidated accountsIn the second section of the chapter, we look at the accounts of insurance panies,where the plex nature of the business necessitates special features in the accountsa The examination is likely to test your knowledge of terms such as subsidiary panyyour ability to calculate goodwill, and your understanding of the construction of groupaccounts and insurance pany accountsThe Actuarial Education CompanyIFE: 2009 ExaminationsPage 2CT2-11: Group accounts and insurance pany accountsConsolidated financial statementsLarge industrial organisations are often organised as groups of interrelatedpanies. There are a number of reasons why this may be so. Historically, thepanies within the group could have been acquired as going concerns. Themanagement of the controlling pany could have felt that there were politicalor marketing considerations which would have made it unwise to transfer theassets of the controlled pany to the acquirer and to liquidate the panyitself1.1 Subsidiary paniesThe pany which holds the controlling interest in the others is known as theholding pany". The panies which are controlled by the holdingpany are known as subsidiaries". Collectively, a holding pany and itssubsidiaries are known as a groupA controlling interest can arise in a number of ways. the most obvious would bewhere the holding pany owns a majority of the voting rights. It is, however,possible to control the subsidiary in other ways. a holding pany could holdless than half of the voting shares but still have the right to appoint or removedirectors holding a majority of the voting rights at board meetings or it couldhave some other right to exercise a dominant influence over the subsidiary(eg by holding a"golden share"in the subsidiary or by entering into a contract giving itthe right to exercise control).Let us take the example of two panies, H (for holding) and S(for subsidiary). Ifmpany h owns 100% of the shares of Company S, Company S is said to be a whollyowned subsidiary. Where the holding is less than 100%, Company S is said to bepartially owned1.2 Consolidated balance sheetsLegally, the panies in the group retain their independence. In many cases,however, the business activities of the group members are closely related to oneanother, with group members supplying others with products or ponents ordifferent group members manufacturing plementary product ranges. It isalso mon for group members to provide fellow members with financeC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsPage 3Even in the case of industrial conglomerates where there is no direct linkbetween the businesses of the members, all of the panies are under thecontrol of the same senior management. It would be illogical for most purposesto view the group as being anything other than a single economic entity. Theshareholders of the holding pany will certainly be more interested in theperformance of the group as a whole than they will be in that of the holdingpany taken on its ownDecisions on how to structure a pany can be plex, and are discussed at length inthe many corporate finance and management books. The desire is to promote someform of petition between the various managers of the subsidiary panies and tosplit the group into manageable, semi-autonomous units, but at the same time to have aspirit of co-operation between all sections of the conglomerateThe holding pany is required to publish a set of consolidated financialstatements which reflect the economic reality of the group's existenceThe holding pany is obliged to publish a consolidated ine statement andbalance sheet. These statements must ply with the format and disclosurerequirements which apply to individual paniesBasically, consolidation is a process of totalling the various items in the inestatements and balance sheets of the individual group members. However, itmust always be borne in mind that the purpose of the exercise is to present thestatements as if the group was a single economic unit. Certain balances in thestatements of the individual group members arise from relationships within thegroup and must be cancelled out before the figures can be meaningfullybinedFor example, H Ltd acquired 10,000 shares in S Ltd on 31 December 200X. thebalance sheets of the two panies at that date were as follows:H Ltds Ltd£000£000Non-current assetsInvestment in S LtdCurrent assets12Total assets3016Share capital (E1 shares)10Current liabilities10Total equity and liabilities30The Actuarial Education CompanyIFE: 2009 ExaminationsCT2-11: Group accounts and insurance pany accountse can imagine that the balance sheet of H before the purchase of s looked very muchIS it does at present, except that instead of having a f10, 000 investment, it would havehad an extra i10.000 of cash in current assets. From the above it can be seen that h ltdnow owns the whole of s ltd, ie it owns t10,000 worth of s shares, which correspondsto the amount of the issued share capital of Company S. In fact the amount of theinvestment could be more or less than the par value of the share capital. If H had paidsubstantially in excess of the fl per share nominal value for the s shares, then theexcess payment could be included as goodwill in the balance sheet of H Ltd. Theexample above assumes that this was not the case. Goodwill is discussed further in thenext subsectionCompany s has no reserves built up from previous years'earnings. Were this the case,the amount paid by H for 100% of S would almost certainly differ from the amount ofthe share capital alone. The amount paid by H would be parable to the net assetvalue, ie total capital and reserves in the balance sheet of sIf this group is looked at from the outside, it can be seen that the directors ofH Ltd control non-current assets with a book value of E14,000(ie E8, 000+ E6,000)and current assets of f22, 000 (ie E12, 000+ E10,000). The group has currentliabilities of E16,000. The calculation of the book value of the group's assets andliabilities is, therefore, a simple matter of adding across the statementsBefore doing so, however, it is necessary to cancel out any internal relationshipswhich arise within the group For example, the holding pany shows an assetf E10,000 in respect of its investment in the subsidiary. This is matched by acapital balance of E10,000 which appears in the subsidiary's balance sheetIn other words, if we were to simply add all the entries in both balance sheets together,we would encounter some double counting problems. The f10, 000 which appears as aninvestment in H's balance sheet is the value of owning Company S and all of thesurplus assets that Company S possesses. However if we have added across bothbalance sheets, all the assets of s are already accounted for in the balance sheet of H, sothe investment double counts these assets It would be removed in a set of consolidatedaccountsIf we were to add the share capital liabilities together we would be reflecting theliability to Ss shareholders in Hs accounts. However S's shareholders are now hsshareholders. Since Hs shareholders already own all of the assets on hs balance sheetthere is no need to include that eitherC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsPage 5Once these have been offset against one another, the consolidated balancesheet would appear as follows:H Group(Consolidated balance sheet£000Non-current assets14Current assetsTotal assets23Share capital(E1 shares)Current Liabilities16Total equity and liabilities36The process of identifying and cancelling internal relationships can beemore plicated in practice. Such problems are, however, beyond the scope ofthclausThe holding pany would also prepare a consolidated ine statement. Therinciples are the same as for the balance sheet in that any transactions betweengroup members would have to be cancelled before totalling across thestatements1.3 Goodwill on consolidationDefining goodwi∥In many takeovers, the amount that H has to pay to s's shareholders exceeds the balancesheet value of the share capital and reserves of Company S. In this case, a balancingitem known as"goodwill"is needed. This is a consequence of the way in which theconsolidated balance sheet for a holding pany with a subsidiary is drawn upGoodwill is calculated ascost of acquisition-book value of shares acquiredThe cost of the acquisition is the value of any cash paid out, plus the market value of anyshares or debt paid out, to S's shareholdersThe book value of shares acquired means the value of the proportion of the share capitaland reserves that Company h owns as a result of the acquisitionThe Actuarial Education CompanyIFE: 2009 ExaminationsCT2-11: Group accounts and insurance pany accountsAccording to FRS 7, the assets and liabilities of a newly acquired undertaking should bebrought into the consolidated balance sheet at their fair values at the date of acquisitionFrom a group perspective the net assets of the subsidiary at the date of acquisitionbee net assets of the group at the date of acquisition rather than when acquired bythe individual subsidiary. Therefore, the historical cost principle should be applied atthe date of acquisition and an estimate made of what it would cost a purchaser toacquire the individual assets and liabilities of the subsidiary at the date of investment bthe group. So, effectively, the subsidiary's assets are revalued immediately before theacquisition by the holding panyTaking the example above, let us assume that the fair value of the net assets of s is equalto the nominal value of S's share capital (ie f10,000), and that h has acquired 100% ofthe shares of S for fll, 000(rather than f10, 000). Goodwill would be E1, 000Why would a pany pay more for another pany than it is worth? Remember thatthe balance sheet only values certain assets- some notably the value of the skilledworkforce and the customer base, are excluded from the balance sheet. The panypays extra to acquire these"off balance sheet assetsAs we have seen, any amount paid in excess of the nominal value of the sharesand reserves acquired by a holding pany is known as"goodwill". In theory,this is the amount which the holding pany is paying for such intangibles asthe reputation of the subsidiary, its customer base and its loyal workforce.Goodwill is often called"goodwill cost of control". You can understand this intuitivelyas the extra amount paid in order to persuade S's shareholders to part with their shares,over and above the value of the shares acquiredAccounting for goodwillGoodwill as a non-current assetGoodwill is normally shown as a non- current asset in the consolidated balance sheetUsing our examplethe amount shown as an investment in h's balance sheet wouldbe ell, 000 rather than E10,000 and presumably H would have less cash as a result, so thecurrent assets would be fll,000(rather than f12,000). Now if we try adding bothbalance sheets together we find that the book value of the assets of s are not equal to theamount of the investment shown in Hs accounts. The difference is goodwill and remainson h's balance sheet after the consolidation the balance sheets would look as followsC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsPage 7H LtdS Ltd Consolidated£000£000£000Non-current assets(incl goodwill)Investment in S LtdCurrent assets110Total assets1636Share capital (tl shares)Current liabilitiesTotal equity and liabilities301636Non-current assets have a value of f15,000 that includes fl, 000 of goodwill onconsolidationSplitting up goodwillNew accounting guidelines state that"goodwill"ought to be broken down into itsconstituent parts where possible, eg brand names, patentiFRs 3 deals with the accounting treatment of goodwill. Under IFRS 3, if abusiness is acquired it is necessary to record all separately identifiabletangibles. Many assets which would previously have been treated as part ofgoodwill must now be identified and valued separately. Valuing these assets canbe a plex matter in many cases and will often require specialist adviceVariations in the treatment of goodwillNormal prudent accounting practice has been to write off goodwill over a period lessthan or equal to the useful life of the asset. This could be very hard to determineHowever, under iFrs 3 goodwill is no longer amortised(depreciated) but is insteadsubject to an annual impairment testingIf, in the example above, the calculation of goodwill had resulted in a negative amountit would have indicated that H had purchased assets cheaply, enhancingvalue of H. Therefore the negative amount would be added to the "other reserves " item(so that"other reserves"increase). This is just like the residual item of shareholderscapital and reserves being increased by"profit"on the issue of shares(which increasesshare premium account")and retained profit from the ine statement(whichincreases"retained earnings")The Actuarial Education CompanyIFE: 2009 ExaminationsCT2-11: Group accounts and insurance pany accountsGoodwill on the purchase of an associateThe accounting item"goodwill"does not appear in the consolidated balance sheet whenanassociate'"(see Section 1.5)is purchased. The value of the associate is taken to bewhatever it cost. Hence, there is no need for a goodwill item to appear in theconsolidated balance sheet, because the value of the associate will be balanced exactlyby the amount of money or loan stock or shares which the holding pany has paidout. However, panies do show the goodwill element of an associate acquisition in anote to the accountsQuestion 11.1Balance sheets (in fs) for Company A and Company B are shown below. Shares inCompany a have a par value of 50p, and those in Company b a par value of 25,Non-current assets 200100Current assets440Share capital300160Reserves400Current liabilities300Calculate the goodwill cost of control assuming that Company A's shares are priced atpar, and that B's shareholders are offered 1 share in a for every 1 share in b when A(1) 100% of Company B(ii) 75% of Company B1. 4 Minority interestsDefining minority interestIt is unnecessary for the holding pany to own all of the subsidiary's sharecapital in order for it to exercise control. In most circumstances, the holdingpany will have control if it owns 50% or more of the shares or if it canotherwise control the subsidiary pany. Given that the directors of theholding pany control all of the subsidiary's assets, it would not beappropriate to consolidate only that percentage which the holding pany canclaim to own. This leaves the problem of accounting for the portion of thesubsidiary's finance which is provided by the other shareholdersC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsPage 9The value of the share capital and reserves provided by the subsidiary,'s minorityshareholders is called the"minority interestAccounting for minority interestThe minority interest must be shown separately in the balance sheet, in theequity section, after the capital and reserves attributable to equity holders. Anexample isEQUITYCapital and reserves attributable to equity holders of thepanShare capitaOther reserves15000Retained earnings80.000135,000Minority interest10,000Total equity145000Let's take another example. Suppose that Mr x decides that he wants to expand hisbusiness by acquiring 80%of the business of his friend Mr Y. The balance sheets of thetwo businesses are as followsall figure in SMr yAssetsCash200Trade receivables20Total assets250250Equity and liabilitiesCapital (sl nominal)50200ReservesEquity250Loan100Total equity and liabilities250Mr X pays $240 for his 80% stake in the business of Mr Y and raises this cash byincreasing his loan from $100 to $340The Actuarial Education CompanyIFE: 2009 ExaminationsPage 10CT2-11: Group accounts and insurance pany accountse can say the followingMr X has acquired 80% of the shares in Mr Ys business= 160 shares ofSI eachThe value of his 80% holding is 80%X($200+$50)=$200The goodwill included in his paymentcost of acquisition- book value of shares acquired- $240-$200=$40The minority holding retained by mr y has a value ofS250-$200=$50To plete a consolidated set of accounts we can consider that Mr x owns andcontrols all of the assets in both panies, but that Mr Y has provided some of thecapital for the bined pany in the shape of his minority stakeWe can now consolidate both balance sheets and eliminate internal relationshipsall figures inMr XMr YUnconsolidatedConsolidatedAssetsShares in mr y240Goodwill200Trade receivablesTotal assets250540Equity and liabilitiesCapital ($I nominalCapital and reserves attributable150150to equity holders of the panyMinority interestsTotal equity15025020034Total equity and liabilities490250C lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsTo reach the final column we have done the followingdded the cash of both panies togetherIded the goodwill to the consolidated balance sheet(this would be held underintangibles "in the non-current asset category)added all other categories together such as trade receivables togetheradded the book value of Mr Ys minority shareholding as part of the equity ofthe consolidated pany.Notice that the share capital and reserves of Mr Ys pany disappear- to includethem would be double counting these liabilities as discussed earlier1.5 Associated paniesApart from holding panies and subsidiaries, there is a third type of groupmemberAn associated undertaking is one which is not a subsidiary, but which is subjectto significant influence(but not control) by the holding panyThere is normally a presumption that significant influence would arise if theholding pany owned more than 20%of the associate' s voting rights. Formost purposes, it is adequate to assume that a holding of between 20% and 50% of S'sshares will make s an associate pany of hThe fact that the holding pany can merely exert influence means that itwould not be appropriate to include the value of its assets in the consolidatedfinancial statements. By the same token, it would be inappropriate to treat theassociate as a simple investment. Instead, promise is reached by includingthe holding pany,'s share of the associate's results in the consolidatedine statement- regardless of whether it actually receives these by way ofdividend. The consolidated balance sheet includes the holding pany's shareof the associates assets and liabilities the entries in both the inestatement and balance sheet are single line entries, which state the totalamounts attributable to associate panies.The Actuarial Education CompanyIFE: 2009 ExaminationsPage 12CT2-11: Group accounts and insurance pany accountsQuestion 11.2a plc owns shares in three panies, B Ltd(40% shareholding, C Ltd(100%shareholding) and D Ltd(25% shareholding). a plc has a contractual right to appointtwo thirds of the board of B ltd. a plc has used its voting rights to appoint all of thedirectors of C Ltd. Which panies are subsidiaries of a plc and which areassociates?1.6 Interpretation of consolidated financial statementsOne should always be aware of the artificial nature of the group structure.Strictly, the group has no legal identity. It is impossible to enter into a contractwith a group Any relationships will be with one or more of the group'smembersIn theory, it would be possible for a group member to collapse without receivingany support from the other group members. In practice a large group would findit almost impossible to permit a subsidiary to fail without pensating thepany's creditors because of the adverse publicity which such an actionwould create. It is also possible to insist on a formal guarantee from the holdingpany as a condition of granting a loan to a group member.Any support between group members could be constrained by the fact that someubsidiaries may be located overseas and subject to exchange restrictions orother local regulations which prohibit the remittance of funds back to headoffice. Alternatively, minority shareholders might be able to block transactionswhich would be damaging to their particular pany even though they werepotentially beneficial for the group as a whole.It is also notable that the accounting techniques associated with consolidatedfinancial statements have recently been one of the most controversial areas forregulatorsQuestion 11.3Define the following terms(i) holding pany(ii) subsidiary pany(iii) associated undertaking(iv) minority interestC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsIn the past, examination questions on this topic have been quite factual. For exampleExplain what is meant by the term"associate pany and explain how associates aretreated on consolidation. (April 2000)Explain how a holding pany would construct a set of consolidated financialstatements. (April 2002)Multiple-choice questions have sometimes required an interpretation of the definitionsof subsidiary and associate panies, and also the calculation of goodwillThe Actuarial Education CompanyIFE: 2009 ExaminationsPage 14CT2-11: Group accounts and insurance pany accounts2 Insurance panies2.1 IntroductionInsurance panies are effectively subject to the same reporting regime as any othertype of limited pAs for other panies, a balance sheet and an inestatement must be producedUp until this point we have concerned ourselves with the balance sheets of parwhere the owner of the entity is clearly defined, and the concept of a profit wasrelatively intuitive. For example, if a pany buys raw materials for $100 this actionin itself would not generate a profit. As such it would not appear in the inestatement of a typical pany. When those raw materials are processed and beealeable goods and are subsequently sold for $200, then the profit-making transaction isregistered in the ine statementWith an insurance pany, nothing is quite so clear-cut. When a policy is sold, thepolicyholder pays the pany a premium and the pany incurs sales andadministration expenses. However, at this point the pany does not know for surehow much profit it will make on the policy as the policy may last for many yearsduring which time the pany will have to pay claims and incur expenses and furtherpremiums may be paid. To allow for these future cashflows, the pany will set up anestimated liability in its balance sheetThe amount of profit that is shown in the ine statement for this first year willdepend upon the size of the liability in the balance sheet and could be either negative orpositive. A conservative approach may be adopted in estimating the liability to avoidtoo much profit being made at the start of the policy when there is still a lot ofuncertainty. Further profits or losses will e through in future years as cashflows onthe policy occur and as the expected value of the liability is updated each yearThe preparation of insurance pany accounts is plicated by two specialfeaturesThe underlying contracts (liabilities) fall due outside the accountingperiod and are uncertain in sizePremature transfer of "profit"to shareholders may endanger the financialstability of the pany and the ability to meet future liabilitiesorder to address these features insurance accounts contain special featuresC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsThis section looks at the special features of insurance pany accounts. We considerboth general insurance(short-term insurance, eg car or buildings insurance)and long-erm insurance(eg life insurance)2.2 Estimation of liabilities and timing of profitEstimated values for future liabilities have to be assessed either on a statisticalbasis or by expert judgement. For long-term(life and pensions) business this isoften entrusted to actuaries. Premiums already received in respect of suchliabilities need to be identified and held until such time as the liabilities haveexpired. Additional sums may have to be set aside to meet any anticipatedworsening in claims experience or any failure by third parties to honour theirmitments towards meeting eventual liabilities.As a consequence, the provisions made for future liabilities are likely to beconservative in nature with the result that current profit is under-stated thisconflicts with the basic accounting principle that the accounts should show atrue and fair"view of the position of the panThis feature is exacerbated by the profit profile of the majority of long-termcontracts, whereby business written initially causes a financial strain due to thecosts of setting up the contracts and establishing adequate initial reservesHowever, the product design will provide for these initial costs to besubsequently recovered, and will also aim to provide an overall return to thepany. The question arises as to when(and how) this profit should bereportedThis feature of life insurance business is known as new business strain, which refers tothe typical pattern of cashflows on a life insurance policy where the expense outgo(onsales and administration) is concentrated in the first one or two years of a policy. This,bined with the fact that liabilities(sometimes referred to as reserves) need to be setup on the policy to allow for future claims, usually leads to losses in the first yeaHowever, looking at the entire term of the policy, the premiums should be sufficient togive an overall profita further problem is introduced by the taxation environment whereby particularclasses of business may operate under different tax rules(for example generalinsurance is taxed differently from long-term insurance). This may require that theoverall activities of the pany are allocated to separate sub-funds for taxpurposesThe Actuarial Education CompanyIFE: 2009 ExaminationsPage 16CT2-11: Group accounts and insurance pany accounts2.3 Ine statementThe ine statement for an insurance pany is divided into technical and nontechnical accountsIn general, all items relating to the main insurance business are shown in the technicalaccount. This is divided further into separate accounts for general and long-termbusinessThe non-technical account then brings together the profits from the two types ofbusiness and adds in any profit made on other non-insurance businessother items such as the investment return on investments other than those supporting theinsurance business and tax on profit to give the overall profit to shareholdersThus, the ine statement will typically appear in three forms-separaterevenue("technical" ) accounts for general insurance and long-term insurancebusinesses and a"non-technical" ine statementTechnical accountsEach revenue account will take the formEarned premiums(net of reinsurance)Investment ineRealised capital gainsClaims incurred(net of reinsurance)or benefits payableNet operating expenses incurred including investment expenses)Balance on revenue accountwhere the investment ine and realised capital gains are those earned on theinvestments held to cover the insurance liabilities. There may need to betransfers from the reserves to cover the actual liabilities which are payableThere may be additional items in the revenue account depending, for example,on pany practice, accounting standards, regulatory requirements, or thepurpose of the accounts. For general insurance these could include any changein the claims equalisation provision (a type of reserve usedfluctuations in claims from year to year). For long-term business, they couldinclude transfer to or from) the"fund for future appropriations"(ie all funds theallocation of which- either to policyholders or shareholders- has not beendetermined by the end of the financial year This can be thought of as a specialype of reserve applicable to life-insurance businessC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsFor general insurance or long-term business, unrealised gains or losses oninvestments might be includedNon-technica/ accountThe balances on the revenue accounts are then transferred to the nontechnical" ine statementThe non-technical account takes the formBalance on general insurance revenue accountBalance on long-term insurance revenue accountRealised and unrealised gains(losses)on investmentsProfit (or loss )from other ordinary activities before taTax on profit (or loss) from all activitiesProfit or loss for the financial yearwhere investment ine and capital gains are those earned on investmentsrelating to shareholders' funds free reserves. (See Section 2.4 for furtherdiscussion of the investment split.other ordinary activities"would be other business activities of the panythat are not general or long-term insurance business2. 4 Balance sheetRemember the balance sheet equationAssets= Liabilities CapitalWe can see that some of the assets of the business cover the liabilities and some of thassets cover the capital (or shareholders' fund or free reserves).The balance sheet contains the usual items plus, typically, these additionalentriesThe Actuarial Education CompanyIFE: 2009 ExaminationsPage 18CT2-11: Group accounts and insurance pany accountsAssetsAssets held to cover insurance liabilities- Insurance panies consider thnature of their liabilities and invest in appropriate assets. For example, long-term insurers tend to invest in medium- and long-term assets whereas generalinsurers tend to have a large proportion of short-term assetsAssets representing free reserves- The shareholders' fund or free reserves isthe value of the share capital and reserves of the business. The greater the freereserves, the more freedom the pany has in its investment policy forexample, it could invest in long-term assets that yield a greater returnReinsurers' share of technical provisions- If the insurance pany is usingreinsurance, then some of its claims will be paid by its reinsurer. This meansthat the liabilities that it holds can be adjusted. This adjustment can be made byshowing an asset in the balance sheetDebtors (trade receivables) arising out of direct insurance operations(policyholders, shareholders)-eg amounts owed to the pany bpolicyholders or sales intermediariesDebtors (trade receivables) arising out of reinsurance operationsie amounts owed to the pany by reinsurersPrepayments (ieIts paid in advance )andd ine(iethat has accrued on a bond since the last coupon payment)LiabilitiesFund for future appropriations- This is the special type of reserve applicableto life-insurance business mentioned in the section on the ine statementTechnical provisions:long- term insurance business provisions including the actuariallyestimated value of the pany's liabilities including bonusesalready declared and after deducting the actuarial value of futurepremiumsC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsgeneral insurance business provisions, including unexpired riskreserves and outstanding claims reserves. Thired riskreserve is to cover the claims and expenses that are expected to emergefrom an unexpired period of cover. The outstanding claims reserve is tocover the claims and expenses for all outstanding claims that have not yetbeen settledShareholders'FundIn insurance pany accounts, the assets less the liabilities equals theshareholders' fundsInsurance pany accounts will be considered in more detail in the relevantSpecialist subjectsSimilar issues arise with respect to pension scheme accounts. Again, therelevant Specialist subjects will address these.Question 11.4State where the following items appear in the accounts of an insurance the following abbreviations: R for revenue account; I foIne(i) revaluation reserveinvestment ine earned on investments relating to insurance liabilities(ii) balance on general insurance revenue account(iv) unexpired risk reserve(v) reinsurers' share of technical liabilitiesThis work on insurance pany accounts was new to Subject CT2 in 2005 and so far(up until April 2008) only one two-mark multiple choice question has been asked onthis topic. Be prepared for questions on the special problems of preparing insurancepany accounts and on the differences between insurance pany accounts andnormal pany accountsThe Actuarial Education CompanyIFE: 2009 ExaminationsCT2-11: Group accounts and insurance pany accountsThis page has been left blank so that you can keep the chaptersummaries together for revision purposesC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsChapter 11 SummaryGroup accountsConsolidated accounts are needed when one pany owns a substantial proportion ofanother pany. These accounts reflect the operations of the whole group owned by theparent or holding panySubsidiary panyCompany S is said to be a subsidiary pany of Company h when Company h has acontrolling interest in Company S. Company H might hold the majority of the shares ofCompany S or might control the board of directors of Company S in some other wayIf Company H owns 100% of the shares in Company S, S is referred to as a wholly ownedsubsidiary. If H owns less than 100% of the shares in S, S is referred to as a partiallyowned subsidiary. The portion held by other shareholders is termed"the minoritConsolidated accounts must be produced for the holding pany and its subsidiariesAssociated panyCompany a is an associate of Company H if Company H has an investment in the sharesof Company a that gives Company H a significant influence over the operating andfinancial policy of Company A. For most purposes, it is adequate to assume that aholding by H of between 20% and 50%of As shares will make A an associate of HThe consolidated ine statement and balance sheet of the group include single lineentries showing the holding panys share of the associate's ine, assets andliabilitiesAn investmentWhere a holding is too small to be an associate (ie less than 20%) it is shown as aninvestment in Company Hs balance sheet. Consolidated accounts are not producedThe Actuarial Education CompanyIFE: 2009 ExaminationsPage 22CT2-11: Group accounts and insurance pany accountsUnconsolidated accountsEach pany within a group of panies will have its own(unconsolidated) set ofaccounts. Within these accounts, Company H's holding in other panies will simplybe shown as an investment in Hs balance sheet. The ine received by way ofdividends will appear in the ine statementThe subsidiary andate panies'own accounts will not be affected by the factthat Company h holds a certain proportion of the sharesGoodwillGoodwill represents the excess of the value paid for a subsidiary pany over the valueto the predator pany of the share of assets purchased. It can also be called goodwillost of control. It is shown in the consolidated balance sheet of the groupMinority interestIn the consolidated balance sheet, the value of the subsidiary's share capital and reservesthat is owned by minority shareholders is shown separately in the equity section, after thecapital and reserves attributable to equity holderInsurance paniesInsurance panies plete their accounts in a manner parable to other limitedpanies. However the nature of their liabilities is such that there is often a conflictbetween prudence and the need to provide a true and fair view of the pany's likelyprofitabilityThe ine statement is divided into technical and non-technical accounts. Interms, the technical or revenue accounts show the profit made on the main insurancebusiness and is split into a general business account and a long-term business account.The non-technical account adds in other sources of profit to show the profit attributableersThe balance sheet has a similar format to a normal balance sheet. but includes additionalitems such as the various types of actuarial reserves, and assets and liabilities relating toreinsuranceC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsChapter 11 SolutionsSolution 11.1(1) Company A acquires a 100% share of Company BB's share capital is worth 160 and the shares have par value 25p, so the number ofshares in B=640a therefore needs to offer 640 of its own shares with a value of 640 x0.50= 320The total value of b to a is the value of 100% of its share capital and reserves, ie160+80=240The goodwill cost of control is the difference between the value of A's shares given toBs shareholders and the value of A's holding in B, iegoodwill cost of control=320-240=80(i) Company A acquires a 75% share of Company BWe know that B has 640 shares. A is acquiring 75% of480 shares. A needs tooffer 480 of its own shares to bs shareholders The value of these shares is480×0.50=240The value of 75% of b to a is(160+80)×0.75=180TIereforegoodwill cost of control240-180=60The Actuarial Education CompanyIFE: 2009 ExaminationsPage 24CT2-11: Group accounts and insurance pany accountsSolution 11.2C Ltd is a subsidiary because A Ltd controls a majority of voting rightsB Ltd is also a subsidiary because A Ltd controls a majority of the boardD Ltd is an associated pany.Solution 11.30 Holding panya pany which holds shares in other paniesSubsidiary panyA subsidiary is a pany controlled by a holding pany. This control may bethrough holding a majority of voting rights or by being able to appoint or removedirectors holding a majority of voting rights at board meetings(iii) Associated undertakingAn associated undertaking is one which is not a subsidiary, but which is subjectgnificant influence by the holding pany. There is normally a presumption thatsignificant influence would arise if the holding pany owned more than 20% of theassociates voting rights(iv) Minority interestThe minority interest is the value of the share capital and reserves provided by thesubsidiary's minority shareholdersC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-11: Group accounts and insurance pany accountsSolution 11.4The shareholders' fund prises share capital and reserves. Reservesinclude the revaluation reserve.)(ii) R(iii)r(the bottom line) and carried forward to I(iv)The Actuarial Education CompanyIFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capitalChapter 12Interpretation of accounts-Security of loancapitalSyllabus objectives(ix) Interpret the accounts of a pany or a group of panies and discuss theimitations of such interpretationI. Calculate and explain priority percentages and gearinCalculate and explain ine cover and asset cover for loan capital3. Describe the possible effects of interest rate movements on a highly gearedpany.0 IntroductionIn Chapters 9 and 10 you have seen how accounts are piled and in Chapter 3 you haveseen how tax is calculated. Yet you are studying to bee an actuary, not a taxaccountant. The knowledge you have gained in the previous chapters needs to be appliedto areas of more direct actuarial interest. One area where your knowledge of accounts canbe used is in the analysis of pany accounts. Such analysis is useful for two specifiareas in which actuaries are involvedthe appraisal of panies for investment purposesunderstanding the way in which the financial institutions which employ actuariespresent their resultsThe next two chapters introduce many of the tools needed to analyse accounts for thesepurposes(further analysis is introduced in subjects at the specialist level). These chapterscontain definitions of several key accounting ratios with which you are expected to befamiliaThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 2CT2-12: Interpretation of accounts- Security of loan capitalAccounting ratios are a useful way to make parisons between panies. Inparticular, by using a ratio rather than a single number, it is possible to make parisonswhich are not distorted by the size of the panies. Ratios are practical tools used byinvestment analysts eg when deciding which share to purchase. Consequently, thereoften no"right"definition of a particular ratio. Indeed, often there is no "right "ratio tolook at in a particular case. In this chapter and the next we set out the most importantratios,in the form(s)in which they are most monly used. If you read othernotes/textbooks you should expect to find differences, although these should usually be onpoints of minor detailIn this chapter we focus on loan capital and the type of analysis primarily relevant toinvestors in loan capital. In particulalook at measures to assess the security of loancapital. We mentioned these briefly in Chapter 4 when we were looking at thecharacteristics of pany debt from the point of view of the investor. This section of thecourse should help to fill in any gaps of understanding from ChapterTo illustrate ratio calculations, we will use the accounts set out below for Cover-upLimited a supplier of specialist equipment and technical advice to governments. Fromtime to time you will need to refer back to the next two pages. It may be useful to markthem so that you can find them easily as you work through the chapterunderstanding of the ratios and their limitations(you will have to explain what they meanor could mean)and your ability to evaluate policies (you will have to offer possiblecourses of action for the pany)Corporation taxAs mentioned in Chapter 3 (Taxation), for ease of calculation, we will assume acorporation tax rate of 30% in this chapter, unless otherwise statedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capitalIne statement for Cover-up Ltd for the year 2007£O0sRevenue250000Increase in stocks of finished goods and work in progress(700)Raw materials and consumables(95000(30,000)Gross profit118,000Administrative expenses and other overheads(85000Operating profit33,000Finance ine2,000Net profit before interest and taxation35,000Finance costs9,950)Net profit before taxation25,050Ta(8,267)Net profit after taxation16.783Profit for the period attributable to equity holders of the panyEPS for profit attributable to equity holders10.5pNotes to the accounts:The pany proposes to make a dividend payment of E6, 000,000, ie 3.75p perordinary share, in respect of the year ending 3 1 December 2007.The Actuarial Education CompanC IFE: 2009 ExaminationsPage 4CT2-12: Interpretation of accounts- Security of loan capitalBalance sheet for Cover-up Ltd as at 31 December 2007£000ASSETSNon-current assetsIntangible assets20.000Tangible assets75.00095,000Current assetsInventories42,000Trade receivables60.000Cash14.000116.000Total assets211,000EQUITY AND LIABILITIESCalled up share capital (160 million shares(@ 25p)40,000Retained earnings20,000Other reserves10,000Total equit70.000Non-current liabilities10% unsecured loan stock 201025.00011% subordinated loan stock 201319.00097 4% mortgage debenture 201116.000912% Eurosterling 200940.000Total non-current liabilities100.000Current liabilitiesavables32.0009,00Total current liabilities41.000Total liabilities141,000Total equity and liabilities211,000C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capitalPage 51 Measuring risk associated with loan capitalIn general, if a pany has a high level of operating profit in relation to the annuainterest due on its loan capital, the loan interest should be secure. The higher the ratio ofpany will default on its loan capItal interest payment r profits to deteriorate before aprofits to interest payments, the more scope there is fcWe can also consider what happens if the pany does default on its interest paymentsWhether the loan stock holders get any money back depends on whether the availableassets of the pany are sufficient to meet the claims of the loan capital holders. Toassess this, investors in loan capital can look at the ratio of the available assets to theamount of the loan stock. a high ratio gives scope for future reductions in the value of thepany's available assets without endangering the asset security for the loan capital. Soassets and ine are important in this contextThe two ratios used to measure this are called the asset cover and the ine coverLoan capitaShareholders will normally regard loan capital as a mixed blessing. It is a cheapsource of finance for the pany because it normally carries a relatively lowrisk for the lenderQuestion 12.1Explain the remark"loan capital normally carries a relatively low risk for the lenderThis means that the shareholders will normally expect to enjoy a higher rate ofreturn from their investment in share capital if the pany is partly financed byborrowing. The alternative would be that additional finance would have beenraised by the sale of additional shares, thereby diluting the returns enjoyed bythe original shareholdersThere is, however, a downside to this. The security enjoyed by the lenders hasthe effect of increasing the risk attributable to the shareholders. This is partlybecause the interest has to be paid regardless of whether the pany ismaking profits and partly because the greater the proportion of the pany 'sassets that are financed by debt, the greater the risk that there will be nothingleft for the shareholders if the pany failsThere are a number of ratios which can be used to measure the risks borne bythe shareholders because of the pany's borrowing policy. these should notbe confused with the risks which arise because of any volatility in the underlyingbusiness itselfThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 6CT2-12: Interpretation of accounts- Security of loan capital2 Ine cover and ine priority percentages2.1 ne coverIne cover on an issue of loan capital is defined to be profit on ordinaryactivities before interest and taxation divided by the annual interest paymentsdue on that issue of the loan capital and on all prior ranking loan capitalIne cover=profit on ordinary activities before interest and taxationannual interest payments due on that issue of loan stock all prior loan stockCrudely, it measures the number of times that the pany could pay its interestout of profit before tax and interest. the higher this multiple, the less likely thatthe pany will run into difficulty.Ine cover is sometimes called "interest coverTo calculate the ine cover on the different types of loan capital issued by Cover-upLtd, we need first to split up the"interest payable on long-term debt". The interestpayable on a particular issue of debt can be calculated from the nominal amountoutstanding and the interest rate shown in the balance sheetBelow we set out the split of interest in order of priority. The mortgage debenture(highestranking)es first. The unsecured loan stock and Eurosterling will probably rankequally. The subordinated loan stock will rank lowestC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capitalPage 7Calculation of ine cover for Cover-up LtdInterest on 9/4% mortgage debenture1,560(00975×16,000Interest on 10% unsecured loan stock2,500(0.10×25,000Interest on 972% Eurosterling3,800(0.095×40,000)Interest on 11% subordinated loan stock2090(0.11×19,000Ine cover on mortgage debenture35,0001.56035.000Ine cover on unsecured loan stock4.5(1,560+2,500+380035,000Ine cover on Eurosterling1,560+2,500+3800)Question 12.2Calculate the ine cover for the subordinated loan stockIt is normally considered risky if the pany cannot cover interest at leasthree or four times. This is, however, a very crude rule of thumb. If, forexample, the pany has a stable, predictable stream of profits then it couldafford to operate with a lower interest cover. In addition, there should normally bea trade-off between lower security and a higher expected return.The main limitations of ine cover are that it does not consider how volatile profitsare, nor does it take account of the length of time for which the loan is outstanding. Forexample consider the likelihood of default on the following two loan stocksa 25-year loan stock issued by a pany with profits that fluctuate greatly fromyear to year with an ine cover of 5x2. a 5-year loan stock issued by Sainsbury (stable profits) with an ine cover of 2xIt is likely that the second is much safer than the first, despite the lower ine coverfgThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 8CT2-12: Interpretation of accounts- Security of loan capitaldepending upon the stability of profits and the term of the loan stock being analysedIt is also sensible to calculate the average ine cover from the last few years'accountsrather than rely only on the latest set of accounts. This will enable the analyst to makesome allowance for the volatility of profitsFinally note that default by the pany on anmy of its loan stock may result in thepany winding up. This may be bad news for all of the other loan stock holders(particularly if the pany's assets are insufficient to repay all of the loan capital). So itis mon practice to calculate ine cover on all the pany's issues of loan capitalnot just the particular issue that an investor is considering purchasinQuestion 12.3A student accountant ments that"since a pany can pay interest on a loan stockeven when profit before interest and tax is negative, it is meaningless to calculatene coverHow would you reply to this?2.2 Ine priority percentagesIne priority percentages show the slice of profit on ordinary activities beforeinterest and tax which covers the annual interest payments due on each issue ofoan capitalIf the ine cover for the loan stock in question is x and the ine cover for the loanstock immediately prior in ranking to the one in question is y, then the ine prioritypercentage for the loan stock is-toFor each issue of loan capital there will be a lower and upper ine prioritypercentile. The lower percentile is calculated as the inverse of the cover figurefor the previous highest-ranking issue. The upper percentile is calculated as theinverse of the cover figure for the issue of loan stock being considered thimay seem plex, but it will bee clear when you work through an exampleC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capitalPage 9This statistic is more relevant to lenders. If the pany has, say, given somelenders a fixed charge or a mortgage over specific assets then these loans willbe repaid before loans with floating charges. Unsecured loans will be repaidafter these. this ranking will be relevant to a lender who has to decide whetherthe other loans that the pany has taken out will affect the risk of a furtherinvestmentCalculation of ine priority percentages for Cover-up LtdIssue of loan capitalInepercentages(see aboveMortgage debenture22.440%to4.5%Unsecured loan stock4.454.5%to22.5%Eurosterling4.454.5%to22.5%Note: 2 decimal places are shown here because ine cover is being used as anintermediate calculationQuestion 12.4Calculate the ine priority percentages for the subordinated loan stockWe can interpret the priority percentages in the above example as followsGiven a figure of f35,000 available to pay the interest on the loan capitalthe first 4.5% of this amount is needed to meet the interest on the highest rankingloan capital(the mortgage debenture)the next 18%(of the t35,000)is needed to pay the interest on the next highestranking loan capital ( the unsecured loan stock and the eurosterlinthe next 6% is needed to pay the interest on the lowest ranking loan capital (thsubordinated loan stock)The Actuarial Education CompanC IFE: 2009 ExaminationsCT2-12: Interpretation of accounts- Security of loan capital3 Asset cover and asset priority percentages3. 1 Asset coverAsset cover on an issue of loan capital is usually defined to be total assets lesscurrent liabilities less intangible assets all divided by the balance sheet amountof the loan capital and all prior ranking loan capitalAsset covertotal assets - current liabilities intangible assetsloan capital+(all prior chargesThis amount will usually represent a conservative estimate of the amount ofmoney available to meet the loan stockholders' demands for repayment if thepany were to wind up. The assumption is that assets other than intangibleswill be converted into cash at their book values, while intangible items are likelyto be worthless on winding up. This is, of course, dependent on the nature ofthe business and its assets. a valuable brand name or patent might well beworth more than all of the pany' s other assets put together currentliabilities are assumed to be repaid before the stockholders even though theymay rank below the loan capitaAn alternative less conservative definition of asset cover istotal assets less current liabilities less intangiblesbalance sheet amount of loan capitalHowever, we will be using the first definition in the following examplesFor Cover-up Ltd, total assets less current liabilities less intangible assets equals &150,000(211,00041,000-20,000The idea is that the assets could be converted into cash at the balance sheet valueHowever, intangible items (eg goodwill) are likely to be worthless on winding up, sothey are excluded. Current liabilities are assumed to be repaid before the stockholderseven though they may rank below the loan capital. The reason for this is that paniesgetting into trouble may find it difficult to get credit from their suppliers and might havevery low current liabilities by the time loan stock holders have the pany wound upIt is standard practice to regard a class of loan which has an asset cover lessthan two or two and a half times as high riskC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capitalCalculation of asset cover figures for Cover-up Ltd150.000Asset cover on mortgage debenture=9416.000Asset cover on unsecured loan stock150.00019(16,000+25,000+40,000Asset cover on eurosterling150,0001.9×(16,000+25,000+40,000)Question 12.5Calculate the asset cover for Cover-ups subordinated loan stockThe main limitation of asset cover is that the current value shown in the balancesheet for assets might not reflect their realisable market value if the pany iswound up The going concern concept means that there is no particular need tocarry assets at their market values.The minimum of 2x cover gives a safety margin, but an arbitrary one. Also, like inecover, capital cover does not take account of the term of the loan stockAn investor is likely to modify the 2x rule of thumb depending upon the likely realisablevalue of the assets, the term of the loan stock being analysed and the adequacy of theIne coverThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 12CT2-12: Interpretation of accounts- Security of loan capital3. 2 Asset priority percentagesAsset priority percentages show the slice of total assets less current liabilitiesless intangible assets which is available to cover the nominal value of eachissue of loan capital. For each issue of loan capital there will be a lower andupper percentile. The lower percentile is calculated as the inverse of the coverfigure for the previous highest-ranking issue. the upper percentile is calculatedas the inverse of the cover figure for the issue of loan stock being consideredQuestion 12.6Calculate the asset priority percentages for Cover-up's subordinated loan stock andinterpret the figuresC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capital4 GearingGearing refers to the relative proportions of long-term debt and equity finance ina pany. High gearing means that the pany has a high level of debtfinancingIn the US, gearing is known as"leverage'There are many different ways of defining gearing. The mon feature is that highgearing means that the pany has a high ratio of debt finance(eg loan capital) to equityfinance(ie share capital and reserves)Gearing can be measured using the balance sheet figures for debt and equityAlternatively, the figures from the ine statement showing the amount of ine beinpaid to debt and earned by equity each year can be used. Three main ratios under eachtype are considered below. The definitions will be illustrated using the data for Cover-upLtd given earlier4. 1 Asset gearingAsset gearing is also known as"capital gearingThere are two monly used definitions of asset gearing, either:borrowingsborrowingsequityborrowings equityThe term"borrowings"will usually include all forms of long- term loan capital(loan stock, Eurobonds, debentures etc). Some analysts also include any part of anoverdraft or other short-term borrowing which seems to be a permanent feature of thepanys capital structure.The term "equityin this definition means the balance sheet value of theordinary shares ie " capital and reserves". It is normal to deduct the amount ofany intangible assets from this quantity. By doing this, we are effectively"writing offintangible assets against reserves, which is what a lot of firms do anyway. This is sensiblesince we need to be consistent between panies, only some of which choose to showintangible assets in their balance sheet. For example, it is much easier to deduct goodwillfrom the minority of panies that show it, than to add an unknown amount of goodwillto the balance sheet of those panies that do not show goodwilThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 14CT2-12: Interpretation of accounts- Security of loan capitalThe treatment of preference shares varies. Usually they are included as part ofborrowings rather than as part of equity because they carry a fixed rate ofdividend and because their holders are repaid before ordinary shareholders inthe event of default. This is appropriate if you are analysing gearing from theperspective of ordinary shareholders. This means that they are more like liabilitieswhen viewed from the perspective of the ordinary shareholders. The treatmentof preference shares within related ratios, such as ine cover, needs to beconsistentA pany whose gearing reached 40% using the second of the above formulaewould normally be regarded as high riskWhere the data is available, and depending on the purpose of the calculation, someanalysts like to use market values of loan stock and share capital instead of the balancesheet valuesExampleUsing the first definition given above (ie borrowings to equity), asset gearing for Coverup is calculated as25,000+19,000+16,00+40,000100,000200%40,000+20,000+10,000-20,00050,000So Cover-up is pretty highly geared by most measuresQuestion 12.7Calculate asset gearing for Cover-up using the second definition of gearing(ie debt tototal capital)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capitalThe reasons for gearing increasing risk can be illustrated with the followingexample involving two identical panies, one financed by 4 million ordinaryshares of f1, the other by 2m shares and f2m of 12% loan stockAverage yearLowgear HighgearEarnings before interest and tax540,000540000(240,000)Earnings before tax540.000300.000Tax(30%)(162,000)(90,000)378,000210.000No of shares4m2Earnings per share(pence)945p10.5pNote: See Chapter 13 for a definition of earnings per share(EPS)if needed.Thus, the shareholders benefit from gearing in an average year because thenterest rates are relatively low (note that 12% would not on its own be consideredlow, but in parison to the return enjoyed by the equity shareholders who contributed£4 million capital of540,00013.5%, the interest rate can be considered low) and4.000.000because the pany enjoys the benefit of tax relief on the loan interestWe now consider the effect if the profits doubleGood yearLowgearHighgearEarnings before interest and tax 1, 080, 0001.080.000Interest(240,000)Earnings before tax1,080,000840,000Tax(30%)(324,000(252,000)756000588,000No of shares4m2mEarnings per share(pence)189pTimes average years ePs2.8xThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-12: Interpretation of accounts- Security of loan capitalIn a good year, earnings before interest and tax have doubled. This results in adoubling of the returns to shareholders in the low-geared pany. the highgeared pany has, however, had its shareholders' return increase 2. 8 timesThis is because of the effects of the fixed payment of interest on the half of thelong-term finance which es from borrowingHowever, if profits halveBad yearLowgearHighgearEarnings before interest and tax270,000270,000Interest(240,000)Earnings before tax270,00030.000Tax(30%)(9000)18900021,000No of shares4m2mEarnings per share(pence)4.7251.05pTimes average years EPS0.50.1The gearing effect is even more pronounced when the pany has a poor year.In this case, halving the earnings before interest and taxation halved theshareholders'return in the ungeared pany. The highly geared panyseturn was reduced to one tenth that of a normal year.The gearing ratio is important because increasing the proportion of debt in thepanys long-term finance tends to accentuate any volatility in the underlyingbusiness. This would tend to increase the total risk for shareholders Inextreme cases, where it might force the pany to risk default, it might alsocreate some risk for lendersC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capitalPage 17An associated ratio used by financial analysts is the shareholders'equity ratioshareholders'equity intangiblestotal assets - current liabilities- intangiblesThis is similar to the second definition of asset gearing, but this ratio looks at theproportion of finance provided by equity, rather than the proportion provided by debtThe higher this ratio, the stronger the financial position of the organisation thelower the proportion, the more possibility of the organisation being overdependent on outside providers of capital (ie sources of finance other thanThe term shareholders'equity in this definition means the balance sheet value of thecapital and reserves. It is normal to deduct the amount of any intangible assetsQuestion 12.8Calculate the shareholders'equity ratio for Cover-upThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-12: Interpretation of accounts- Security of loan capital4.2 Ine gearingThe most monly used definition of ine gearing isinterest on borrowingsprofit on ordinary activities before interest and taxInterest on borrowings"will usually include all forms of interest payable ondebt (ie on loan capital, and on overdrafts)Question 12.9Define "a highly-geared panyThe treatment of preference shares again varies. When they are included as partof interest on debt", they should be grossed up at the pany's rate ofcorporation tax. So the definition would beinterest on borrowings+preference dividends(1- corporation tax rateprofit on ordinary activities before interest and taxYou may wonder why we are grossing up dividends at the corporation tax rate. Theanswer is that we are assessing how much interest cost the pany is bearing. The costto the pany of Ex of preference dividends at the before tax level is Ex/(1-t)(assuminga corporation tax rate of n)Question 12.10Calculate ine gearing for Cover-up LtdC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capitalChapter 12 SummaryIne cover on an issue of loan capital is defined to be the profit on ordinary activitiesbefore interest and taxation divided by the annual interest payments due on that issue ofthe loan capital and on all prior ranking loan capitalIne priority percentages show the slice of profit on ordinary activities beforeinterest and tax which covers the annual interest payments due on each issue of loancapitalAsset cover on an issue of loan capital is defined to be total assets less current liabilitiesless intangible assets all divided by the balance sheet amount of the loan capital and allprior ranking loan capitalAsset priority percentages show the slice of total assets less current liabilities lessintangible assets which is available to cover the nominal value of each issue of loancapitalGearing refers to the relative proportions of long-term debt and equity finance in apany. High gearing means that the pany has a high level of debt financinThere are two monly used definitions of asset gearing, eitherborrowingsborrowings equityAn associated ratio is the shareholders equity ratioshareholders'equity - intangibletotal assets-current liabilities- intangiblesThe most monly used definition of ine gearing isnterest on borrowingsprofit on ordinary activities before interest and taxThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-12: Interpretation of accounts- Security of loan capitalThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capitalPage 21Chapter 12 SolutionsSolution 12.1To explain the term "low risk?we have to look at all the possible risks to the investorand explain why the risk is lowDefault riskLoan stock capital ranks higher in the event of a wind-up thanequity and preference shares. In this respect it can be described asrelatively low riskMarket riskBecause the ine flow is fixed and the security is better thanequities, it is generally the case that the market price of debtsecurities is more stable than that of equity capital. Therefore themarket risk is relatively lowReinvestment risk This is the risk that the ine from the investment cannot bed to give the same level of yieldThe risk of lower yielding reinvestment is arguably the same forloan capital as for equityOverall the risk is clearly lowerSolution 12.235,000ne cover1,560+2,500+3,800+2,003.5Solution 12.3It is true that a pany can pay interest on a loan stock even when profit before interestand tax is negative, but only if it has the spare cash (or an overdraft facility) available. Ifthe losses persist, the pany might run out of cash and default on the loanThe long-run success of a pany depends upon it making profits. It is thereforesensible to consider the pany's profits(and hence ine cover) when assessinwhether or not to invest in the pany. This is particularly the case since there is nobetter, simpler alternative of assessing the panys likely future successThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-12: Interpretation of accounts- Security of loan capitalSolution 12. 4The ine cover figure for the unsecured loan stock and Eurosterling issues is 4. 45XThe ine cover figure for the subordinated loan stock is 3. 52The ine priority percentages for the subordinated loan stock are therefore2.5%to28.4%Solution 12.5150.000Asset cover=1.5×16,000+25,000+40,000+19,000Solution 12.6The asset cover for the unsecured loan stock and eurosterling issues is 1. 85xThe asset cover for the subordinated loan stock is 1,50xThe asset priority percentages for the subordinated loan stock are thereforeie54.0%to66.7%1.851.5This means that, if the pany were wound up, the first 54% slice of the panysassets would go towards covering the pany's liabilities to the holders of the mortgagedebenture. unsecured loan stock and Eurosterling issue. The next 12. 7% slice of thepany's assets would go to the holders of the subordinated loan stockSolution 12.7100.000Asset gearing66.7%100.000+50.000C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-12: Interpretation of accounts- Security of loan capitalSolution 12.8Shareholders'equity ratio70000200033.3%170.000-20.000Solution 12.9A highly geared pany is a pany that has a high ratio of debt finance to equitSolution 12.10ne gearing9,950=284%35.000The Actuarial Education CompanC IFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisChapter 13Interpretation of accounts- Shareholder analysisSyllabus objectives(ix) Interpret the accounts of a pany or a group of panies and discuss thelimitations of such interpretationCalculate and explain price earnings ratio, dividend yield, dividend cover andEBITDA5. Explain net earnings per share6.Calculate and explain accounting ratios which indicateprofitabilityefficiency0 IntroductionIn Chapter 12 we looked at ratios which would interest potential investors in loan capitalThese figures looked at the security of the pany in terms of its ability to meetcontractual obligations to holders of loan capital. We now turn our attention to theshareholdersInvestors in ordinary shares are entitled to receive dividends, which may be verylarge relative to the issue price of the shares if the pany is successfulEqually, the dividends may not be paid at all if the pany is unsuccessful.Whilst ordinary shareholders may look at cover and gearing ratios, ine and capitalcover will not be their main concern. Instead they will want to know about apany,'s profitability, efficiency, earnings for ordinary shareholders anddividends. These features can also be studied by looking at ratiosThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 2CT2-13: Interpretation of accounts- Shareholder analysisThis chapter looks at the following sets of ratiosratios involving share informationprofitability ratiosliquidity ratiosefficiency ratiosWe will use the accounts of Cover-up ltd to calculate various ratios these are shown ofthe next two pagesAs we said in Chapter 12, the examination is likely to test your knowledge of accountingratios(you will have to know the definitions and calculate them) but more importantlyyour understanding of the ratios and their limitations(you will have to explain what theymean or could mean) and your ability to evaluate policies(you will have to offer possiblecourses of action for the pany)Corporation taxAs mentioned in Chapter 3(Taxation), for ease of calculation, we will assume acorporation tax rate of 30% in this Chapter, unless otherwise stated.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisPage 3Ine statement for Cover-up Ltd for the year 2007Revenue50.000Increase in stocks of finished goods and work in progress(7,000)Raw materials and consumables(95,000(30,000)Gross profit118,000Administrative expenses and other overheads(85,000Operating profit33,000Finance ine2,000Net profit before interest and taxation35,000Finance costs(9,950)Net profit before taxation25,050Tax on ordinary activities(8,267)Net profit after taxation16.783Profit for the period attributable to equity holders of the panyEPS for profit attributable to equity holders10.5pNotes to the accounts:The pany proposes to make a dividend payment of E6, 000,000, ie 3.75p perordinary share in respect of the year ending 3 1 December 2007The Actuarial Education CompanC IFE: 2009 ExaminationsPage 4CT2-13: Interpretation of accounts- Shareholder analysisBalance sheet for Cover-up Ltd as at 31 December 2007£000sASSETSNon-current assetsIntangible assets20.000Tangible assets75.00095,000Current assetsInventories42,000Trade receivables60.000Cash14.000116.000Total assets211,000EQUITY AND LIABILITIESCalled up share capital (160 million shares(@ 25p)40,000Retained earnings20,000Other reserves10,000Total equit70.000Non-current liabilities10% unsecured loan stock 201025.00011% subordinated loan stock 201319.00097 4% mortgage debenture 201116.000912% Eurosterling 200940.000Total non-current liabilities100.000Current liabilitiesavables32.0009,00Total current liabilities41.000Total liabilities141,000Total equity and liabilities211,000C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisPage 51 Ratios involving share information1.1 Earnings per sharen principle, earnings per share is a simple conceptearnings on ordinary activitiearnings persharenumber of issued ordinary sharesWithin this context, earnings on ordinary activities are usually taken to mean earningsfor ordinary shareholdersThe earnings per share(EPs)ratio is the amount of profit that has been earnedfor each ordinary share. It is customary to calculate this ratio by taking the netprofit after taxation and, since it is concerned with the ordinary shareholdersposition, it excludes any preference dividend- ie the payments in respect ofpreference dividend are deducted from the earnings before the calculation of the ratioBusinesses whose shares are publicly traded are required to disclose twoversions of earnings per shareBasic earnings per shareThis is calculated by dividing the net profit or loss for the period attributable toordinary shareholders by the weighted average number of ordinary sharesoutstanding during the period. The net profit or loss attributable to ordinaryshareholders is after taxation, minority interests, extraordinary items andpreference dividendsDiluted earnings per shareThe basic EPS takes into account only those equity shares in issue that wereoutstanding during the period. However, a pany may have entered intoobligations that could dilute the EPs in the future. In such cases, the basic EPsshould be adjusted for the effects of all dilutive potential ordinary shares. thecalculation should be made on the assumption that any conversion rights oroptions had been exercised in full on the first day of the accounting period. (fthe date of issue of the securities giving rise to the rights or options is later, aweighted average calculation should be performedThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 6CT2-13: Interpretation of accounts- Shareholder analysisExamplea pany has earnings on ordinary activities of t75m for the year ending31 December 2007. During the year, there were 500m ordinary shares in issue. OnJuly 2007, E50m of convertible loan stock was issued, with the option to convert intoordinary shares in 2017. Under the conversion terms, if all of the loan-stock holderstake the option to convert 100m new ordinary shares will be issued£75.000.000The earnings per share for 2007 are500.000.00015p per shareSince we had 500,000,000 shares for 6 months and a potential 600,000, 000 for thesecond six months. the weighted average number of shares allowing for conversionrights is:0.5×500,000,000+0.5×600,000,000Therefore, the diluted earnings per share are£75,000.000(0.5×500,000010.5×600,000013.6p per shareThere are various other ways of calculating EPS. For example, some paniesprovide additional EPs figures that exclude exceptional items or excludediscontinued operationsIt is difficult to see why the EPs ratio should mand so much attention Thenumber of ordinary shares is, after all, a meaningless number. A panywishing to raise Elm of share capital could, for example, issue 1m E1 shares, 2m50 pence shares or 10m 10 pence shareshe EPs figure is, in fact, used as the basis for the calculation of the PriceEarnings(P/E)ratioQQuestion 13. 1A pany's pre-tax profits have doubled over the past 4 years but EPS have hardlygrown at all. Give two reasons why this might have occurredC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisPage71.2 Price earnings ratioprice earnings ratio market price of an ordinary shareearnings per shareThe earnings per share figure used in this ratio can be historical or prospective.The Financial Times(FT) publishes price earnings(PE) ratios using the current marketshare price and the reported net earnings per share from the most recent 12-month periodover which the pany has reported(where possible, interim accounts are used to updateearnings taken from end-year accounts). This is known as an"historical "PE ratioMost investment analysts will calculate a pe ratio based on their best estimate of thepany's earnings over the next 12 months(but still using the current market price)This is known as a"prospective"PE ratioSome panies do not pay the standard rate of corporation tax on their profits(eg theymay charge a different rate of depreciation from the rate of capital allowance allowed bythe Inland Revenue). In these cases, some analysts will recalculate a panys earningsas if it did pay the standard rate of corporation tax on its reported profitsWhere panies have convertible shares, warrants or share options that may at somepoint be converted into new shares, it is mon to calculate the pe ratio on a"fullconversion basis" using diluted earnings per shareThe market price of the share encapsulates everything that the market knowsabout the pany. Relating this to earnings gives an insight into the marketsopinion of the pany,'s performance. If the price earnings ratio is high thenthat would suggest that the pany is relatively attractive when considered asa source of revenues. This might imply that the market believes that thepany is a relatively low risk investment or that earnings will grow rapidly inthe futureIf the Ple ratio of a share is high relative to other, similar panies(taking theabove factors into account) it may mean that the share is overvaluedUse of the price earnings ratioEarnings are the amount of money generated by the pany for its shareholdersThese are of fundamental importance in determining the ine a shareholder receivesand also the potential for growth of the panyThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 8CT2-13: Interpretation of accounts- Shareholder analysisThe price earnings ratio shows how many times bigger the price of a share is than theearnings that the share produces. There are two main reasons why investors might beprepared to pay a bigger multiple of the earnings for one share than for another sharethey expect earnings to grow rapidly, so they are really paying for expected highfuture earnings2. the earnings are considered to be less riskyTo use this ratio sensibly, you should consider the likely growth prospects of the pany,and thus derive the pe ratio that you think the share should have. The share is thenexpensive(cheap) if the actual PE ratio is higher (lower) than your estimated Pe ratioOne way of estimating the Pe ratio that a pany should have is to consider what isnormal for the industry to which the pany in question belongs. A pany whoseshares have a Pe above the norm for the industry may be considered expensive(or to havebetter than average growth prospects)In theory(and almost certainly in practice) the P/E ratio will vary as a result ofchanges in the share price. Unfortunately, many directors behave as if therelationship has been inverted. They seem to assume that the p/e ratio is fixed(or is at least "sticky")and that the share price can be improved by overstatingthe ePs1.3 Dividend yield(gross) dividend yieldgross dividends per sharemarket price of an ordinary shareNote that we have defined the dividend yield using gross dividends, where"grossdividends "means including the 10% tax credit. ( This is in contrast to the Pe ratio whichused net earnings. Since the uK government has removed the right of tax-exemptinvestors to reclaim the tax credit(other than through a few tax-exempt savings vehicles)the concept of gross dividend yield has bee more theoretical than practicalUse of gross dividend yieldIn theory, the value of a share is the discounted present value of the proceeds you obtainfrom owning it. If you hold it forever, the present value of a share can be taken to be thediscounted value of all future dividends. Thus dividends are of key importance toshareholdersC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisPage 9The dividend yield measures the amount of current ine(dividends)aninvestor receives per unit of investment (the share price). A low dividend yieldmay mean that1. investors expect dividends to grow rapidly, or2the share is overvaluedNote that the gross dividend yield cannot be interpreted as the expected returnon a share because it shows only part of the return for an investor-it ignoresany potential capital gain(or loss ).1.4 Dividend coverdividend coverearnings per sharedividends per shareDividend cover can be calculated on either a net basis or on a gross basis( wheregross dividends "in the UK means including the 10% tax credit)Note that this way of calculating cover is not directly parable with the inecover used for loan capitalQuestion 13.2Why is it not entirely consistent?The inverse of the dividend cover is the payout ratiodividend per sharepayout ratio= dividend cover earnings per shareUse of dividend coverDividends are paid out of earnings. In the long run, a pany will not be ableto maintain dividends if they are not covered by earnings. In contrast, apany with a high level of dividend cover has more scope to increasedividends in the futureThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-13: Interpretation of accounts- Shareholder analysisSo, for a given dividend yield on a share, a high dividend cover figure suggestsbetter value for money than a share with low dividend cover.Note that there is a relationship between the pe ratio, the dividend yield and dividendIf we use the definition based on net dividends (ie the dividend actually paid) therelationship ismarket price net dividend per share net dividend per shareearnings per sharemarket priceearnings persharePeratiox net dividend yield- payout ratio1.5 EBITDAThe ine statement (as introduced in Chapter 8) shows how Operating Profitreflects Revenue less the Cost of Sales, Distribution Costs, AdministrativeExpenses and other Operating Ine. The Operating Profit plus FinanceIne is sometimes referred to as Earnings before Interest and Taxation(EBIT)The figure does, however, allow for depreciation and amortisation chargesSome analysts feel that these are not well measured in ine statements, sincethe amounts charged are based on subjective analysis and may therefore beseen as discretionary. They prefer to focus on Earnings before Interest,Taxation, Depreciation and Amortisation(EBITDA). This is often referred to ascashflow from operations(The evaluation of depreciation charges was covered in Chapter 9. Amortisationis a similar exercise in respect of intangible assets such as goodwill, advertisingand R&DEbITDa can be used to calculate an alternative version of earnings per share This canthen be used to pare different panies or to look at trends over time for aparticular pany if tax, depreciation or amortisation might otherwise distort thepanisonC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisQuestion 13.3Copies of the ine statement and the balance sheet for Cover-up Ltd are provided onpages 3 and 4Calculate the following ratios for Cover-up Ltd, given that its current share price is200(1) EPS(i) EBITDA per share(iii) PE ratio(using net earnings)(iv) gross dividend yield(v) dividend cover on a net basisAssume that the dividend proposed is approved and paidQuestion 13. 4A UK pany made E5m pre-tax profit last year. It paid a dividend for the year ofto02 per share. It has 100m shares in issue currently priced at fiAssuming corporation tax is charged at 30%, calculate(1) earnings per share(ii dividend cover(iii) gross dividend yield(iv) PE ratioThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 12CT2-13: Interpretation of accounts- Shareholder analysis1.6 Net asset value per shareThe formula for net asset value per share isordinary shareholders equity -intangible assetsnumber of issued ordinary sharesComments on definitionOrdinary shareholders'equity" means called up share capital, other reservescluding share premium account and revaluation reserve and retained earningsIn other words, ""ordinary shareholders ' funds "means all of capital and reserves, excludingpreference capital and minority interestsIf a pany has convertible preference shares or convertible loan capital, it is normal tore-work the balance sheet assuming that conversion occurs immediately(whether or notimmediate conversion is in fact possible). Net asset value calculated like this is known asfully diluted"net asset valueIntangible assets are excluded because they are treated differently by different firms andalso because they may be worth nothing if the pany is wound upPurposeThis shows the balance sheet value of the tangible assets backing each share,net of all liabilities to non-ordinary shareholders. It is approximately what theordinary shareholders would receive for each share they hold if the panywas immediately wound up(assuming the balance sheet values are reliableThe main problem with the ratio is that the balance sheet values in historic costaccounts do not necessarily reflect the true value of the assets. For a highly gearedpany, the net asset value is the small difference between two big numbers, tangibleassets and liabilities. So problems of inaccurate valuation of assets bee particularlyacuteOften, net asset value will be pared to the share price. If the net asset value ismuch greater than the share price, then the shares may be undervalued. Net asset value perhare is particularly useful when looking at property panies and investment trustswhere the share price should be closely related to the net asset value(because the value ofsuch a pany is generally just the value of the underlying assets). Indeed, the FTshowsnet asset value for investment trusts, but not for other paniesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisPage 13Net asset value is also used in take-overs. Part of what you buy when you take over apany is the target pany's assets. So the net asset value gives a guide as to whatshould be paid (or possibly the minimum fair value). If a pany's share price is belotthe net asset value it may be worthwhile taking over the pany simply to acquire itsassets cheaplyIf a pany is about to be liquidated, the share price might be closely related to the netasset value. However, the realisable value of the assets for a pany in liquidation willoften be a long way below the value placed on them in the balance sheet. Remember fromChapter 7 that accounts are piled, and assets are valued, on the assumption that thepany will be a going-concernFor many panies the share price is a lot bigger than the net asset value. This mayshow that the share price is more dependent upon the pany's ability to generate profits(eg due to a good image witassets. For many panies, it is the discounted value of future dividends that determinesthe share price, not the net asset value. a good example might be an advertising agency(or any other"people "based industry) where the value of the firms tangible assets may betiny. However, a low asset value relative to the share price may suggest that the shareprice is too highVariationsMost analysts can partially overe the problem of historical cost values. They do thby replacing the balance sheet value of land with the market value (remember that thisneeds to be disclosed in the directors'report if it is not shown in the balance sheet)However, you would not normally have the information available in the exam to do thisSome analysts, particularly in the US, always divide net asset value per share by thepany's share price, to make the parison between book value and market valueexplicit. If this ratio is less than 1, it means the market value exceeds the book valueIn the examination, you might be asked to discuss which ratio or ratios would be mostappropriate for a particular purpose. For examplea pany could be valued by taking the pany's latest profit figure andmultiplying it by the price/earnings ratio of a quoted pany in a similar line ofbusiness or it could be valued at the net asset value according to the balance sheetExplain the relevance of each of these methods. (April 2005, adapted)The Actuarial Education CompanC IFE: 2009 ExaminationsPage 14CT2-13: Interpretation of accounts- Shareholder analysis2 Introduction to other accounting ratioshere are four main groups of ratiosThose which measure profitability2. Those which measure liquidity3. Those which measure business efficiency4. Those which relate to the business'financial structure (as discussedmovele have already discussed the ratios which relate to financial structure(gearing, etc)in Chapter 12 and Section I of this chapter.In the following sections we look at ratios from the first three groups in the list aboveThese will help to indicate how successful the pany is in various parts of itsoperations. The ratios we look at areProfitabilityreturn on capital employedprofit marginasset utilisation ratioLiquidityarent ratioquick ratio(also called acid test or liquidity ratio)Efficiencystock(inventory) turnover ratiodebtors turnover ratiocreditors turnover ratioC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisPage 15Unfortunately, for many ratios there is no agreed definition and many variations are usedThe approach given in these notes isto give a definition of the ratio(this will usually be the definition most widely usedin past exams2. to explain the purpose of the ratio3. to ment on the terms used in the definition and mention any problems withcalculating itto mention the more mon variations of the definition (where appropriate)We give more detail in this section than the syllabus strictly requires. The reason for thisis that for you to be able tocalculate"the ratio(for different firms, using different accounting terminology),explain what the ratio meansyou need to"understand,what the ratio means. So, bearing in mind the syllabusobjectives, read the following notes to develop an understanding of the ratios. Do not tryto remember all the detail given in these notesThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-13: Interpretation of accounts- Shareholder analysis3 Profitability ratiosThe profitability ratios are used to check that the pany is generating anacceptable return for its owners. a number of benchmarks can be usedprevious years' figures, ratios calculated for similar businesses, industryaverages, etc. Management should consider the reasons for any ratios whichare poorer than expected to see whether they imply that performance could beimproved3. 1 Return on capital employedDefinitionReturn on capital employed is the most important profitability ratio- indeed it isoften referred to as the primary ratio"or"return on investment". It measuresthe relationship between the amount invested in the business and the returnsgenerated for those investorshe calculation of return on capital employed is plicated by the fact thatcapital employed can be measured in a number of different ways. It is vitallyimportant that the figure for "return"is calculated in a consistent manner withthat for"capital employedThe two main formulae for return on capital employed arenet profit before tax and interestshare capital reserves long-term debf700andnet profit before taxx100share capita/ reservesThe first formula defines capital employed in terms of the total amount investedin the pany, both by shareholders and lenders. In order to be consistent, thefigure for return must show the total amount generated on behalf of theseinvestors. That is why interest has been added backC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisPage 17The important thing is consistency between denominator and numerator. Thetwo main rules to obey areif, and only if, an asset is included in the denominator, should the ineit gives rise to be included in the numerator.(ti if a liability is deducted from the denominator the ine paid to it shouldbe deducted from the numeratorComments on definitionThis ratio is normally expressed as a percentageThe term"before interest"means before interest payable but after interest receivableNote that the denominator (often called"capital employed")is virtually the same figureas is used when calculating asset cover. The definition above uses""share capital plusIgnoring the intangibles the two definitions are the sameThe ratio is dependent upon the value placed on the assets. Note that assets revaluedupwards might lead to a higher denominator and a lower numerator, since thedepreciation charge would probably increase in future yearsThe denominator would normally be taken as the latest available figure, althougharguably taking the start year figure is sensible because the resulting figure could then beconsidered as a true effective rate of returnPurposeThe ratio can be used to indicate how efficiently managers of different firms areusing the funds at their disposal. It is therefore useful when paringpanies for investment. The ratio can be pared with the cost ofborrowinga decrease in the ratio would be cause for concern and further investigation eg haveprofit margins fallen, have sales fallen or has capital increased without any increase inprofits? Return on capital employed is likely to decrease during recessions, and increasemsThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-13: Interpretation of accounts- Shareholder analysisManagers of panies often use return on capital employed (roce). For exampleThe ratio can be pared with the cost of borrowing. If the return on capitalemployed is likely to be stable, then further borrowing will be a good(bad)ideaif the rate of interest payable on new borrowing is lower(higher) than the returnon capital employedReturn on capital employed can be calculated for parts of a business. If aparticular branch activity produces a very low(high) return on capital employedthen funds should be diverted away from(towards) that activityVariationsJust as with asset cover, a valid variation on the definition of capital employed would be toinclude any long-standing overdraftIf an overdraft is not included in the denominator, any interest payable on the overdraftshould ideally be deducted from the numerator Where an overdraft is included in thedenominator, any interest payable on the overdraft should appear in the numeratorHowever, the information needed to identify interest paid on an overdraft as opposed toother interest payments may not always be availableOther mon variations includenot deducting current liabilities (ie using total assets"or"total equity plusliabilities”)using the average capital employed figure from the start and end-year balancesheetsusing the market value of the pany's capital (share and loan capital) as thedenominatordeducting intangibles from the denominatorC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisPage 19The rocE can be broken down into two"secondary"ratiosasset utilisation ratiorevenue(turnover)share capital reserves long-term debtreflecting the intensity with which assets are employed and(i profit margin(or return on sales ratio)net profit before tax and interestrevenue(turnover)This is an attempt to look at the profits made per unit of sales. It is normal tomultiply the answer by 100 to express it as a percentage.You can see that ROCE is the product of these two ratios as followsROCE=net profit before tax and interestshare capital reserves long-term debtshare capital reserves + long-term debr x net profit before tax and interestrevenuerevenueasset utilisation ratio x net profit marginThis shows that a fall in the roce can result from two main sources: a fall in the profitper unit of sales(measured by the profit margin) or a fall in the sales generated by theassets. Once management has identified the general cause, more ratios can beexamined, such as administration costs per unit of sales, or sales generated by the fixedassets. Having identified the cause, management can suggest a number of policies,eg pricing policy, advertising, cost controlThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-13: Interpretation of accounts- Shareholder analysis3.2 Profit MarginVariationsWe have seen the definition of the net profit margin above. It is also possible tocalculate other sorts of profit margin, eg the gross profit margin or the operating profitmargin. Operating profit is sometimes called trading profit. Remember thatoperating profit does not include interest receivable. This means that the operating profitmargin is of limited use for most financial paniesSome analysts look at operating profit before depreciation has been deductedurposeProfit margins are useful when analysing the profit made per unit of sale. Thedifference between the gross profit margin and the operating profit margin is accountedfor by expenses as a percentage of revenueLow margins relative to other firms in the industry may indicate a wide range ofthings, for examplea more down market product rangea“ low margin high volume” marketing strategyan attempt to increase market sharepoor management/excessive coststemporarily low profits and/or high costs(eg as a new product is launched)subnormal profits are being made, so that the firm will exit the industry in thelong runChanges in the profit margin from year to year will also be of interest toanalysts. such changes could indicate changes in any of the items mentionedaboveClearly, it is impossible to tell whether a high ratio is good or bad without somefurther information to provide context. a higher ratio could be achieved byincreasing selling prices. Unfortunately, that could also have the effect of over-pricing the pany's products relative to its petitionC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisPage 21It is also important to bear in mind that different accounting policies can lead todifferent profitability ratios, For example in the IT software industry, a great dealdepends on the pany's policy of writing off unsuccessful or out-of-date softwaredevelopment costs. One pany can seem very much more profitable thansimply because the latter is prudently writing off development costs on software itbelieves to be out of dateLikewise, different industries exhibit vastly different profit margins. In the retailingindustry, turnover can be high and profit margins will often be narrow. However in thedrug industry, the margin on a successful patented drug is much higherMany analysts use the profit margin and an estimate of future sales to derive a profitsforecastoperating profit margin X estimated revenue= estimated operating profit3. 3 Asset utilisation ratioas we have seen in Section 3. 1. this is defined asshare capital reserves long-term debturposeThis measures the revenue that has been generated by the pany's assets. If this hasfallen, the pany should investigate the reasons. Perhaps the pany has increasedts assets but has not used them efficiently; perhaps the pany has encounteredproduction problems; or perhaps the problem lies in marketing- perhaps revenue hasfallen because of a rise in price, a fall in advertising, increased petition or a generaleconomic recessionThis ratio should be investigated alongside the net profit margin. A pany mightadopt a"pile 'em high and sellem cheap"strategy which would give the pany ahigh asset utilisation ratio but a low net profit marginThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-13: Interpretation of accounts- Shareholder analysis4 Liquidity ratiosWhile it is important for a business to be profitable, profit is not sufficient on itsown to guarantee survival. There must be sufficient liquid assets available toensure that short-term mitments can be met. otherwise the pany couldbe forced into liquidation.4.1 Current ratiocurrent assecurrent ratiocurrent liabilitiesPurposeThis ratio is used to assess whether the pany will be able to pay its billsover the next few months. It provides a parison of an estimate of theamount of money due to be received in the short term with an estimate of theamount of money to be paidLiquidity is important. Many potentially profitable firms have been wound up becausethey have had insufficient cash to meet their short-term liabilities. Many more panieshave had to go to their shareholders to raise extra cash when liquidity has bee aproblemNormally, a low ratio might indicate that a pany may have problems payings creditors. An excessively high ratio may indicate that the management hastoo much money tied up in unproductive short-term assets such as excessivestocks or idle cash balances."Too high"will vary according to the nature of theindustry, eg whether large stocks are needed or what the normal credit terms are fordoing business with suppliers and customers in that industryIt is difficult to know exactly what a low or high figure is for a particularpany. Different industries can have very different "normal"levels. Ingeneral, a ratio of 2: 1 is considered to be optimal. this could, however, beexcessive for businesses which have rapid turnover of stock and steady cashinflow(a supermarket being the classic example). By the same token, a ratio of2: 1 might be inadequate for a business which has irregular cash inflowsBecause of this, many analysts use the ratio to look at trends over a number ofyears. A sudden change would be cause for further investigationThe pany's creditors may also be very interested in using the current ratio to assess afirms short-term solvency.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisComments on definitionThe term "current liabilities"will usually be taken to mean " creditors falling duwithin one year". The figures in the balance sheet will only include those assets andliabilities which exist at the balance sheet dateThere is no guarantee that the time span of the current assets is the same as the time spanof the current liabilities. So a pany with an apparently satisfactory current ratio mightstill have trouble paying a liability due tomorrow. In particular, inventories are included inthe numerator, but it may take some time to plete and sell the finished product, andthen await paymentAs with all ratios, the current ratio's usefulness depends upon the reliability of the valuesshown in the accounts. In particular, the value placed on inventories will depend upon theaccounting methods used. The current ratio may therefore be slightly misleading whenused to pare different firmsThe crucial liquidity factor for many panies is the size of any as yet unused overdraftlimit that they have agreed with their bankers. however this is something that only a fewpanies choose to report. The current ratio is therefore a very crude indicator of aompanys ability to meet its short-term debtsConsistency is achieved by including items in the denominator which are likely to be paidwithin the same span as those items in the numerator, usually a yearVariationsThe Companies Acts do not require a pany to show the split of"provisions forliabilities and charges"between those due within a year and those due in more than oneyear. Treatment of this item varies. It would be normal to leave out provisions forliabilities and charges in an exam. However, if the information is available(eg thepany chooses to give the split anyway), then such items due to be paid within a yearcould be included in "current liabilitiesThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 24CT2-13: Interpretation of accounts- Shareholder analysis4.2 Quick ratioquick ratio a current assets-inventories (stocks)current liabilitiesThe quick ratio is also known as the acid test, or the liquidity ratioPurposeThis is another ratio aimed at looking at short-term liquidity the quick ratioconsiders what would happen if all creditor and debtor accounts were settledimmediately. It focuses on readily realisable cash. The idea is that only cash andtrade receivables (debtors) can be quickly turned into cash, but any of the currentliabilities could bee payable within a few monthsA quick ratio of much less than one might be a sign that the pany maystruggle to pay its creditors. However some panies are able to survive witha ratio of much less than one their customers pay in cash, but they agree andcontinually roll-over, say, 90-day credit terms with their suppliers without any problemsAgain it is often departures from the normal level of the ratio rather than theabsolute level of the ratio which will interest analystsAs with the current ratio, true solvency is often more dependent upon agreements withbankers. than on the ratioVariationsAny marketable investments could be included in the numerator. However, these are oftenignored in practice(and in exams) since the information to decide on the marketability ofan investment may not be availableC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysis5 Efficiency ratiosThe efficiency ratios are related to the liquidity ratios. They give an insight intothe effectiveness of the pany's management of the ponents of workingcapital5.1 Stock(inventory)turnover ratioTraditionally, the stock turnover ratio is defined as:stock(inventory) turnover ratio sstocks(inventories)365revenue(turnover)PurposeThis is an attempt to assess how much stock the pany holds in relation tothe scale of the pany 's operations the ratio attempts to show how longstock is held for on average. If we ignore the difference between the selling price of agood and the cost of producing it, a stock turnover ratio of, say, 1/12 or 30 days wouldsuggest that the average item of stock is held for one monthA stock turnover ratio that is less rapid (ie higher) than other panies in thesame industry might indicate an inefficiently large stock holding. An increasingratio might indicate that sales were slowing down resulting in stockpiling of unsold goodsNote that this ratio will vary enormously between businesses. (Think of the likelydifferences in the stock turnover ratios of a ship builder and a fresh fish retailer!Note that stock turnover cannot be used when considering a financial institution such as abank. The term "stocks "in this context is meaningless, as is the term"turnoverComments on definitionStocks (inventories) include finished goods, work-in-progress and rawmaterialsone difficulty with the ratio is that the figure for stocks may be subject toseasonal variation. So using end-year balance sheet values is potentially misleadingThere is very little that an analyst can do about this. Also, the value placed on stockswill depend upon the accounting method used.The Actuarial Education CompanC IFE: 2009 ExaminationsCT2-13: Interpretation of accounts- Shareholder analysisThe figure for stocks (inventories) es from the balance sheet, and the revenue figurefrom the ine statement. Some analysts will use the latest available figure forinventories, others will use an average of the start and end-year balance sheet figuresQUestion 13.5Why is it a good idea to use an average of the start and end-year balance sheet figuresfor stocks when calculating the stock turnover raticVariationsA very mon variation on the definition is to use the following formula(or itsnverse:stock turnover ratio stocks(inventories)x 365cost of salesThe idea is that it is"cost of sales", rather than turnover, that most closely relates apany's scale of operations to its holding of stocks. This definition gives a betterestimate of the average number of days for which stock is heldQuestion 13.6What does the inverse of the stock turnover ratio(multiplied by 365)tell you?5.2 Debtors turnover ratiodebtors turnover ratio a debtors(trade receivables365credit salesPurposeThis is a measure of the average length of time taken for debtors( tradereceivables) to settle their balanceAgain, it is desirable for this ratio to be as short as possible. It will be better forthe pany,'s cashflow if debtors pay as quickly as possible. It can, however,be difficult to press for speedier payment. Doing so could damage thepany's relationship with its customersC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisComments on definitionThis ratio indicates the average number of days credit that is extended to customerspaying by credit. Note that"credit sales refers only to that part of the total sales of thepany which were transacted on credit, excluding the sales for cashIf the pany sells goods for cash and for credit then it is important to dividethe debtors figure by credit sales onlyIt is not always possible to calculate this ratio because the split between sales for creditand sales for cash is not often published. In some cases it will be realistic to assume thaare negotiated with some form of creditIn this case the ratio can be simplified todebtors turnover ratiotrade receivables(debtors)x365salesIf sales cannot be broken down(into cash and credit sales)then the ratio will bedistortedHowever if the proportion of cash versus credit sales remains constant from year to year,the figures for different years can be pared, even if there is a theoretical distortion5.3 Creditors turnover ratioA similar ratio can be used to assess creditors:creditors turnover ratio a creditors(trade payables)×365account purchasesPurposeThis ratio indicates the average number of days credit that a pany has from itsuppliers. A high ratio indicates that the pany is taking a long time to pay its billsThis may be because it has been able to obtain a long credit period from its suppliers,which will be of benefit to its cashflowThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-13: Interpretation of accounts- Shareholder analysisComments on definitionAccount purchases "are purchases of supplies on creditIt is not always possible to calculate this ratio, as account purchases may not beavailable from published information. In some cases it will be reasonable to assumethat all purchases involve some form of credit and so use total purchases instead.(Recall from Chapter that total purchases can be calculated as the sum of stock usedand the increase in stock over the yearQuestion 13.7() Calculate the following for Cover-up Ltd(a) net asset value per sharecurrent ratio(d) stock turnover ratio(e) profit margin(f) return on capital employed(g debtors turnover ratio(assume 80% of the sales are for credit(h) creditors turnover ratio(assume all purchases are for credit)(ii) Interpret each of the figures you have calculated for each ratio. You can exclude(a)A long(20-mark) examination question might provide you with accounting informationfor two panies or for one pany for two years. You might be asked to evaluatthe perfowith the help of ratio analRemember to ment on the ratios as well as calculate themC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisChapter 13 SummaryRatios involving share informationearnings per sharearnings on ordinary activitiesnumber of issued ordinary sharesmarket price of an ordinary shareprice earnings ratioearnings per share(gross) dividendgross dividends per sharemarket price of an ordinary sharedividend cover earnings per sharenet asset value per shareordinary shareholders'equity intangible assetsnumberof issued ordinary sharesProfitability ratiosreturn on capital employed=net profit before tax and interesichare capitales t long-term debtnet profit before tax and interestprofit marginasset utilisation ratiorevenue(turnover)share capital+ reserves long-term debtThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-13: Interpretation of accounts- Shareholder analysisLiquidity ratioscurrent ratio Current assetscurrent liabilitiescurrent assets - inventories(stocks)quick ratiocurrent liabilitiEfficiency ratiosstocks (inventoriesstock(inventory) turnover ratio365revenue(turnover)stocks(inventories)365debtors turnover'ratio= debtors(trade receivables)365crean salescreditors turnover ratio=creditors(trade payables)365account purchasesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisPage 31Chapter 13 SolutionsSolution 13. 1Possible reasons would include acquisitions by the issue of shares and a higher tax chargethan in earlier yearsSolution 13.2Ine cover and asset cover as defined earlier are calculated by dividing the totaine(or assets) available by the loan stock all prior debt. To be consistent, whencalculating dividend cover, we would have to calculate the total ine available toequity shareholders all prior ranking capital(debt, preference,.)and divide by thedividends on ordinary shares all prior capital. This is not what is doneSolution 13.316,783160,000(i) EBITDa per share35,000130.00040.63p160.000() PE ratiomarket price of an ordinary share200=19.1×(iv) We first need to find the gross dividendnet dividendgross dividend1-0.1066670.96,667×1001gross dividend yield0.02lor2.1160,000200The Actuarial Education CompanC IFE: 2009 ExaminationsPage 32CT2-13: Interpretation of accounts- Shareholder analysis(v) dividend cover on a net basisnet earnings 16, 783net dividends 6.000Solution 130 Post-tax profits is 5mx(1-0.3)=3, 500,000. Divided between 100m shares, thisgives earnings per share of 3.5pDividend cover=-=1.75x(il) Gross dividend yield=(0.92.22%0100(iv) The price earnings ratio is 100/3.5= 28.6Solution 13.5Stock turnover is one of the accounting ratios that use a bination of figures from thebalance sheet and figures from the ine statement. the balance sheet is a set of figuresthat are correct on a particular date, whereas the ine statement covers a period of time(normally a year). Some analysts therefore use an average figure for the balance sheetitem in order to attempt to reconcile this discrepancy in timing between the two sets ofaccountSolution 13. 6The inverse of the stock turnover ratio tells the analyst how many times the stock is turnedover in an accounting periodC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-13: Interpretation of accounts- Shareholder analysisSolution 13.7ia) net asset value per shareNAV per share( using£00)≈70,000-20,000=31p160,000116,000(i()curren=2.841.000116.000-42.000((c) quick ratio.841,000(i(d) stock turnover ratio250000×365=61days(i(e) profit margin35,00050,000(i(f return on capital employed35,000=20.6%170.000((g)debtors turnover ratio60,000×365=110day0.8×250,00032,000(ioh) creditors turnover ratio365=123days95.000(i)(b The current ratio gives an estimate of the panys liquidity. It pares moneydue to be received soon with money due to be paid soon. The figure of 2.8indicates that Cover-up is able to cover its short-term debt(i(c) The quick ratio also gives a measure of liquidity. It uses only the cash or near-cashitems in the balance sheet (as stocks may take a while to sell). A ratio of 1. 8ndicates that the pany is solvent()(d) The stock turnover ratio shows how quickly the pany is selling its output. Thefigure indicates that the pany is turning over its stock every 61 daysie approximately every two monthsThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-13: Interpretation of accounts- Shareholder analysis((e) The profit margin looks at profits per unit of sales. The figure of 14% can bepared with other firms in the same industry((f Return on capital employed represents how efficiently the firms capital is beingused to make profits. It can be pared with the opportunity cost of the capitaland also with the figure for other firms in the same industry. A rOCe of 20.6%would seem to cover the cost of capital(i(g The debtors turnover ratio indicates the number of days credit that is extended tocustomers who request payment on credit. The ratio of 110 days is quite high,indicating that the pany is not operating its credit control function effectively(i)(h)The creditors turnover ratio is also quite high at 123 days. Cover-up may havebeen able to negotiate good credit terms from its suppliersC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-14: Limitations of accountsPage 1Chapter 14Limitations of accountsSyllabus objectives(ix) Interpret the accounts of a pany or a group of panies and discuss thelimitations of such interpretation7. Discuss the shortings of historical cost accounting8. Discuss the limitations in the interpretation of pany accounts9. Discuss the ways that reported figures can be manipulated to create a falseimpression of a pany's financial position0 IntroductionIn Chapters 12 and 13, you have learned how to analyse accounts using a number ofmeasures that may be calculated from pany accounts. In this final chapter of the partwe consider some of the difficulties of using and interpreting accounting informationYour understanding of the limitations of accounts is likely to be tested at the end of a ratioanalysis question. Be prepared also for a link with the regulation of accounts, covered inChapter 7The Actuarial Education CompanC IFE: 2009 ExaminationsPage 2CT2-14: Limitations of accounts1 The shortings of historical cost accountingHistorical cost accounting tends to overstate profits during times of inflation1.1 Valuation of stockIncrease in stock values: the time lag between the purchase of an item of stockand its eventual sale means that panies are constantly understating costs ofsales. If, for example, an item is purchased for f1 and sold for E1.50 thepany will record a profit of E0. 50. If, however, the cost of replacing that itemof stock has increased to E1. 30 then the "real"profit on the transaction is onlyE0. 20. This will tend to overstate profits.Looked at another way, part of the cost of selling a good is the reduction in the remainingstocks. This reduction will be calculated on a historical cost basis understating the truecost of replacing the item used up ie profits will be overstated1.2 DepreciationThe depreciation charge will be calculated using the historical cost of theassets. This will tend to overstate profitsIf inflation is positive, straight line depreciation over 10 years on a machine purchased,say,7 years ago will be less than on an identical machine purchased, say, 2 years ago. Thedifference will be particularly significant when inflation is high. In both cases the amountcharged will be less than 10% of the cost of replacing the asset today1.3 Interest paymentsA pany may receive interest on its investments, and pay interest on its loancapital. In times of inflation, part of the interest payment is really pensationfor the erosion of the real value of capital. For a pany that pays out moreinterest than it receives, profits will tend to be understated in times of highinflation. For a pany that pays out less interest than it receives, profits will tend tobe overstated in times of high inflationIn inflationary times, the real value of a loan decreases, so the borrower pays back lessin real terms. Therefore the borrower gains and the lender loses in inflationary timesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-14: Limitations of accountsPage 31.4 Consistency over timeProfits and asset values might be increasing in money terms. But it would notbe immediately obvious how much was due to a real increase in the scale of apany's operations and how much was simply due to inflation. Comparisonbetween years is therefore difficult when using historical cost accounts. Notethat this sort of criticism applies to many items where values have to be pared overThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 4CT2-14: Limitations of accounts2 Limitations in the interpretation of accountsThe limitations of accounts will, in part, depend upon the way that the accounts are to beused. Before reading this section, turn back to the start of Chapter 7 where the range ofpossible uses of published accounts are set out. Using what you know about accountsalready, try and identify the major limitations for each possible useAlmost every number in a set of accounts may be suspect in some respect. We willdiscuss the main limitations under the following( to an extent overlapping) subheadingsSubjectivity - or are the numbers correct?Appropriateness -or"correct " for what purpose?Comparison between firmsSome limitations of ratio analysisAccuracy of figures2.1 SubjectivityAlthough regulations give a lot of guidance as to what are acceptableaccounting principles, firms still use a range of different methods to arrive at theigures to put in their accounts. For exampleStock valuationStock can be valued in a number of ways, eg first-in-first-out or last-in-first-outIt seems unlikely that every firm chooses the "best" method of valuing their stockQuestion 14. 1Describe the difference between using a lifo and a fifo method of book valuationand indicate which of the two methods would increase reported profits in an inflationaryenvironmentC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-14: Limitations of accountsPage 5DepreciationFirms have a large choice as to the depreciation method used. Any method willat best approximate the true pattern of the reduction in the value of a firm' s non-current assetsRevaluation of assetsSome firms revalue their assets when the asset values increase, others do notHowever, note that the directors' report does have to disclose the market value of land ifthis differs significantly from the balance sheet value. Arguably firms that do notevalue assets are showing the wrong figure. On the other hand, paniesclaim that according to the concept of prudence, they should show assets at a prudelow value, and only take account of any revaluation when the asset is sold. Theremany such debates on accounting policies. In recent years there has been a movetowards revaluing assets and liabilities at the end of each accounting periodIntangible assetsThese are often particularly hard to value. a great deal of subjectivity is involved inputting a value on a brand name, for example. Many panies don' t even try to valueintangible assetsThe significance of accounting policies is that they provide limits to the entries in theaccounts that are subject to the exercise of judgement and a check against arbitraryexcessive or unjustifiable adjustments where no other yardstick is available. They providea consistent framework for periodic reporting of the results and the financial position of abusinesThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 6CT2-14: Limitations of accounts2. 2 Appropriateness of the figures usedThe figures presented in the accounts may not be the most appropriate for theurposes of a particular user of the accounts.Going concernThe value of many assets would be much lower on a wind-up basis than on theon-going basis usually assumedPresent valuesThe amounts shown for trade receivables and payables(debtors and creditorsare their face values, not their true present values.Depreciated cost not economic valueNon-current (fixed) assets are shown at their (depreciated historical costArguably, the value to a firm of an asset should be the(discounted) value of thefuture profit stream that the asset is expected to produceAccuracyGiving a true and fair view does not mean that the accounts are absolutelyaccurate. Many items in the accounts will be estimatedEnd-year valuesThe balance sheet shows end of year values, but for many purposes it is moremeaningful to use average values, for example when looking at the level of stocksthat a firm holdsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-14: Limitations of accountsPage 72. 3 Differences between firmsMany users of accounts wish to pare different firmsComparabilityMany of the problems above(eg stock valuation, depreciation method) are worryingnot just because the figures may be wrong, but since different firms usedifferent methods. This makes reliable parisons between firms verydifficultCreative accountingA few firms may deliberately set out to mislead by choosing the accountingpolicies that will maximise reported profitsFormatsThe choice of accounting formats can mean that different firms can producesets of accounts which are difficult to pare.Level of aggregationSome firms show more detailed splits of items than other firms. For example, onefirm might give details of different types of stock, another may just show one aggregatefigureks. When making parisons between firms, the leastdisaggregated item across all firms will be the lowest level at which theaccounts can be analysedThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 8CT2-14: Limitations of accounts2. 4 Some limitations of ratio analysisRatio analysis is a very useful technique for the interpretation of financialstatements It does however, have its limitations Some of these are outlinedbelotDiverts attentionIt diverts attention from the figures and statements themselves. It is importantto look at aspects such as the sheer size of the pany under consideration. Alarger pany will have more bargaining power and may be able to enjoyeconomies of scale. It is also important to look at information in the noteswhich is not usually reflected in the ratios. If someone is suing the pany fordamages this will be disclosed in a note stating the amount claimed andpossibly giving an indication of the expected oute. There will not be anymention of the matter in the balance sheet itselfAppropriate parison?Comparisons can be affected by different accounting policies or by otherexternal factors. If, for example, two haulage panies use different methodsfor the calculation of depreciation then any ratios based on their financialstatements might not be parable. Similarly, two similar businesses could beaffected to different extents by currency movements. a vehicle distributorselling Japanese cars will be exposed to movements in the value of Yen to amuch greater extent than a distributor of British carsDifferent industriesThere could be peculiarities of the trade which make it difficult to interpretcertain ratios. a property pany, say, might appear to have a very low returnon capital employed. One reason for this is that the value of the propertiesshown in the balance sheet will be updated on a regular basis, thus increasingcapital employed. This will make it difficult to pare results with a businesswhose assets have not been revaluedCreative accountingThe statements could have been deliberately distorted by so-called creativeaccounting. This involves the deliberate abuse of the subjectivity inherent inaccounting to select accounting policies or make assumptions which tend tobias the figures in the direction chosen by managementCreative accounting is discussed further in Section 3C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-14: Limitations of accountsPage 92.5 Accuracy of the figuresOut of dateThe figures reported will necessarily be out of date by the time they e to bepublished and read.Window-dressingSome firms have been known to delay transactions so that they occur just afterthe year end, or to advance other transactions so that they are included in theend-year accounts. This then means that the pany,'s accounts can give anaccurate view of the underlying figures, yet still mislead when pared withother firms or over different periodsForecastingAlthough they are only meant to serve as a historical record, accounts are widely usedas a means of predicting the future Interpreting accounts for this purpose isfull of problems. For exampleno indication is given of the firm's plans for the futureno real idea is given of how sustainable the existing profit figures areQuestion 14.2List the problems of interpreting pany accounts under the following headingssubjectivityappropriateness of figures usedparisons between firmsaccuracy of figuresThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-14: Limitations of accounts3 Manipulation of reported figuresAccounting methods can be used to enhance the image of a firm and make itlook better than it is. Such practice will make the current reported profitability apoor indicator of future profitability. Note that the manipulation may involveinflating current operating ine (via an increase in booked sales or adecrease in expenses)or reducing current operating ine in order toincrease future earnings). The latter may be encouraged by the use of executivencentives linked to future performanceIn theory, one of the reasons why the audit process is in place is to prevent suchmanipulation occurring. However, given the level of subjectivity permitted in accounts,sometimes manipulation of figures can still take place whilst plying with accountingolicies and standardsAccounting practices that can lead to such misstatements include:inappropriate depreciation of tangible assetsinappropriate amortisation of intangible assetsinappropriate valuation of stocks and inventoriesinappropriate valuation of future liabilities(including pension provisions)unwarranted revaluation of tangible assetscreating intangible assets of questionable true worthomitting contingent liabilities"prebooking" of anticipated sales revenuesScrutiny of the trends shown by items in the accounts may assist to identifymanipulation, as can consideration of the current status of the pany(andtherefore, the need to manipulate the reported financial position).It must be stressed that such manipulation of reported figures may be illegal andcertainly would be contrary to the professional standards expected ofaccountants and auditorsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-14: Limitations of accountsQuestion 14.3Whilst waiting in the queue for the cinema one day you overhear the person behind youmaking the following statementThe use of pany accounts in investment decision making is fundamentally flawedIn particular, the market value of the pany's assets may bear no relationship to thebalance sheet values. Therefore there is little point in using either the accounts or theratios derived from themComment briefly on this statementa question on the limitations of accounts might be asked at the end of a ratio analye question. For exampleDescribe the limitations of your analysis in (i), explaining why the directors shouldseek additional information before making a final decision. "(April 2001)Here, you would probably discuss the subjectivity in the accounts, the difficulties ofmaking parisons between panies, and the important matters that are notrevealed in the accountsBe prepared also to link this material with that in Chapter 7. For exampleExplain whether it would be possible to restate profit by artificially depressing thedepreciation charge. (September 2002)How can I be certain that these financial statements have not been falsified bydishonest directors?"(April 2004)In this sort of question, you would probably discuss the potential for producingmisleading accounts, along with the regulatory, legal and ethical issues that would serveto safeguard the accountsThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 12CT2-14: Limitations of accountsEnd of part 3You have now pleted Part 3 of the Subject CT2 NotesBefore looking at the Question and Answer Bank we remend that you briefly reviewthe key areas of Part 3, or maybe re-read the summaries at the end of chapters 1 l to 14Question and Answer BankYou should now be able to answer the questions in Part 3 of the Question and AnswerBank. We remend that you work through several of these questions now and savethe remainder for use as part of your revisionAssignmentsOn pleting this part, you should be able to attempt the questions in Assignment X3emingerIf you have not been attending regular tutorials then you may wish to consider booking aplace on a block tutorialC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-14: Limitations of accountsChapter 14 SummaryThere are a number of limitations to the use and interpretation of accounts. TheseIntthe subjectivity inherent in financial statements(and the possibility of creativethe concern about the accuracy of accounting informationthe concern about the appropriateness of accounting informationthe problems of using accounting information to make parisons betweenpaniesthe problems of using ratio analysis to judge performancethe concern about what's missing from the financial statementsThe historical cost accounting convention causes additional problems with theinterpretation of panies' results in times of high inflationReaders of accounts should be alert to the possibility that the accounts have beendeliberately manipulated to give a particular impressionThe Actuarial Education CompanC IFE: 2009 ExaminationsPage 14CT2-14: Limitations of accountsThis page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-14: Limitations of accountsChapter 14 SolutionsSolution 14.1LIFO: Last-in-first-out means that the pany calculates its cost of sales withreference to the cost of the most recently acquired stock. This stock will tend tobe more expensive in an inflationary environment and this will increase the costof sales and decrease the profitsFIFO: First-in-first-out conversely books the earliest stock as cost of sales. In aninflationary environment, stock purchased some time ago will tend to cheaperand this will lower cost of sales and increase profitSolution 14.2Problems of interpreting pany accountsSubjectivityinventories can be valued in a number of wayslong-term contracts can be dealt with in different waysthere is a wide choice of methods of calculating depreciationsome firms revalue their non-current assets periodically; others do notintangible assets may or may not be shown in a pany's accounts; their trueralue is difficult to determineAppropriateness of the figureshould assets be valued on a going-concern or a wind-up basis?should assets be shown at historical cost or at their long-term economic value tothe pany?some items in the accounts will be estimatedthe balance sheet shows end-year values, but average values may be moreappropriate for some purposesThe Actuarial Education CompanC IFE: 2009 ExaminationsCT2-14: Limitations of accountsComparisons between firmsit is difficult to pare similar items between firms when they have useddifferent calculation methodscreative accounting may be a problem with some firmsthe choice of accounting formats may make it difficult to pare the accountsof different paniesdifferent panies will show different levels of detailAccuracy offiguresthe figures in the accounts will be out of date by the time they are publishedirms can delay or advance transactions to manipulate the accounts for aarticular yearaccounts are often used for forecasting even though they are meant purely as ahistorical recordSolution 14.3The nugget of truth in the statement is that pany accounts are prepared on a historicalcost basis, and so take no account of inflation. Companies may from time to time revaluetheir assets, and show the new values in their balance sheets, but they are not usuallobliged to do so. Similarly, panies'depreciation charges will be based on thehistorical cost of their assets. These charges are likely to underestimate the trusing non-current assetsHowever, our cinemagoer goes a little too far(as speakers in this kind of question tendC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-14: Limitations of accountsPage 17Company accounts contain(at least)the following itemsbalance sheetIne statementcashflow statementdirectors reportauditors’ reportEach of these items can be useful in generating a picture of the panyAccounting ratios are useful for making parisons(a) of the pany over time(b) with other paniesBecause of the variations in accounts from one pany to another, ratios cannot beexpected to give definitive answers. They do, however, give valuable indicators as toaspects which may need further investigationFinally, what better source of quantitative information is there, however imperfect thaccounts maThe Actuarial Education CompanC IFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCPage 1Chapter 15Weighted average cost of capitaSyllabus objectives(iv) Discuss the factors to be considered by a pany when deciding on its capitalstructure and dividend policy1. Describe the effect that the capital structure used by a pany will have on themarket valuation of the pany2. Describe the effect of taxation on the capital structure used by a pany(vii Define what is meant by a panmy's cost of capital and discuss how its cost ofcapital interacts with the nature of the investment projects it undertakesDescribe how to calculate a panmy's weighted average cost of capital0 ntroductionIn Part 1 of the course we discussed pany ownership, pany finance and taxationHaving studied the construction and analysis of accounts in Parts 2 and 3, we now returnto the issue of finance. The role of the financial manager is to raise finance, use it forprofitable ventures and earn a satisfactory return for the providers of finance. In thispart of the course we investigate this roleThe fulfilment of the role of financial managers requires that theystructure and restructure the capital of the pany to cope with, and to benefitfrom, the changes in the industry and the changing requirements of the ownerhave the strategic vision that will steer the pany in the future into profitableandketskeep the shareholders informed of the pany's progressmanage the ine payments from the pany to the shareholders andbondholders in a way that is efficient from the panys viewpoint and, withinthis framework maximises the wealth of shareholdersThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 2CT2-15: WACCIn Chapter 16 we will look at one important aspect of the role of the financial managerie the financing decision(how should the funds be raised? ) We also look at the relatedissue of deciding how much of the pany's earnings it should pay out in dividends tothe shareholdersIn Chapters 17 and 18 we will look at the other key aspect of the role of the financialmanager, ie the investment decision( what real assets should the firm invest inThe financial manager should choose to invest in projects that increase shareholdervalue. Chapters 17 and 18 look at specific methods of project appraisal, such as the netpresent value method. Some of the work on project evaluation will be familiar to thoseof you who have studied or are studying Subject CTl. For example, the net presentalue method involves estimating future cashflows from the project and discountingthem to find the net present valueIn this chapter we consider an issue that is relevant to both decisions. The weightedaverage cost of capital (Wacc) is the average cost of raising finance for the businessIt might vary with the gearing(the debt/equity mix) of the pany and so it is relevantto the financing decision. It could also be used as the discount rate in the net presentvalue calculations and so it is relevant to the investment decisionThe later part of this chapter uses the capital asset pricing model(capm) which will becovered in more detail in Subject Ct8s In the past, the examination has tested knowledge of and the ability to calculate thee weighted average cost of capital and the ability to analyse the effect of factors such asgearing and tax on the weighted average cost of capitalCorporation taxAs mentioned in Chapter 3(Taxation), for ease of calculation, we will assume acorporation tax rate of 30% in this chapter, unless otherwise statedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCPage 31 ntroduction1.1 The importance of the weighted average cost of capitalThe role of the financial manager is to raise finance through an appropriate blend of debtand equity(the financing decision )and to use the funds to invest in suitable projects(theinvestment decision The goal of the financial manager is to increase shareholdervalue. They achieve this by investing in profitable projectsIt is now generally accepted that discounted cashflow techniques for evaluatingprojects are far superior to the use of simple payback approaches or accountingrates of return The shareholder value-added approach enhances thesetechniques further. However, to use these techniques requires the calculation ofthe project cost of capital. In the absence of a suitable discount rate NPV andIRR approaches have no meaning. Project appraisal methods are considered inChapters 17 and 18Provided that the project achieves the expected return and that, when adjustedfor the risk of that project, the return is in excess of the pany's weightedaverage cost of capital(WACC), the shareholders are better off than before.o, in order to choose appropriate projects, the pany must know its weightedaverage cost of capital since this will be used as the discount rate in the project appraisalIn this chapter, we are going to find out what determines the weighted average cost ofcapital. In particular, we will ask: does the financing decision (ie the debt/equitybalance) affect the cost of capital? If it does, there is a link between the financingdecision and the investment decision. Additionally, if the value of the pany isregarded as the discounted value of its future profits, then, if the financing decisionaffects the costs of capital, then it affects the value of the pany too1.2 Defining the weighted average cost of capitalAlthough there are many methods of financing a pany they broadly fall intojust the two camps of equity or debtThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 4CT2-15: WACCThe waCC is defined as followsWACCMarket value of debtx net cost of debtMarket value of debt +equityMarket value of equityx cost of equityMarket value of debt +equityNote that here we are dealing with the market value of the equity and debt rather thanthe book or accounting valueRemember that the cost of equity is the total return that is expected by individuals whoinvest in the shares, not simply the dividend yieldIn Chapter 12 of this course we looked at"gearing,, which we defined asbook value of debtof debtbook value of debt t book value of equity bcor egllwhere the book value of the equity is the accounting value of the share capital plusreservesNote that in this chapter we deal with market values. Thus'gearing would be definedmarket value of debtmarket value of debt market value of equity market value of equitywhere the market value of the equity would be the number of issued shares times themarket price of each shareThe cost of debt and the cost of equityNotice that the net cost of debt appears in the formula, wherenet cost of debt gross cost of debt(1-t)here t is the rate of corporation taxInterest payments on debt finance are tax deductible. They appear before the tax line onthe ine statementC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCPage 5The cost of equity which is discussed further below, will tend to be higher thanthe cost of debt in part due to the more favourable tax treatment of debt. thishas led to considerable debate over determining the correct cost of capital touse because the weighted average cost of capital (WAcc)will be very sensitiveto the ratio of debt to equity on a pany 's balance sheetQuestion 15.1If a panys dividend yield is 4%o and the gross redemption yield on its debt is 10%3what can you say about the pany's rate of return on debt and its rate of return onequity?ExampleGrowmore plc has debt with a market value of f100 million trading at a grossredemption yield (GrY of 10% in the market, and E100 million market value of equityAnalysis suggests equity investors are expecting 12% per annum from their investmentIts weighted cost of capital, assuming no tax is paid, could be said to be 11%(ie weighted average of the cost of equity and the gross cost of debt)If the pany can earn 11% return on its assets, it can give a 10% return to the loancapital providers and a 12% return to the equity capital providers. This is the essence ofa weighted cost of capital calculationThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 6CT2-15: WACC1.3 Theoretical backgroundThe traditiona/ viewIn the traditional school the emphasis was on determining the amount of debt apany could safely carry without risking bankruptcy in a severe recessionDebt is cheaper than equity finance, so as gearing increases, the WacC should fallHowever, increasing the proportion of debt finance increases the risk to shareholders soshareholders demand a greater return for this increased risk. Therefore beyond a certainlevel of gearing, the downward effect on the WacC of increasing the debt finance inthe business will be more than offset by the increase in the return required byshareholders. In this case the graph of the WACC against gearing would be U-shapedWACC(%)gearingThe WACC is lowest at C* when gearing is at G*This is potentially very important. It means that changing the capital structure couldchange the profitability of investment projects and result in a change in the value of thepanModigliani and M∥lerIn the late 1950s and early 1960s the traditional school was attacked by modiglianiand Miller(MM)who held that gearing was irrelevant and that each increase indebt carried a pensating increase in the cost of the equity.a key concept in Corporate Finance is expressed in Modigliani and Miller's firstirrelevance proposition: The market value of any firm is independent of itscapital structureC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCPage 7Modigliani and Miller argued that, under certain assumptions, gearing has no effect onthe value of the pany. Their view was that the value of the pany lies inability to produce profits, not in the way that it is financed- in other words, that themarket value of a pany is determined primarily by its investment decisions and notby its financing decisions. This proposition allows plete separation of investmentand financing decisionsHow did they arrive at this view?They began with a simple model with the following assumptionsthere are no taxesunlimited personal and pany borrowing is possible at the same rate ofnterestdebt is risk-freehere are no agency coststhere are no information asymmetriesThe arguments in the MM model revolve round the concept of risk and return. When apany is financed by equity alone, the shareholders only face business risk. As debtincreases in the business, shareholders face increased financial risk as returns beemore volatileIf there are two panies with the same business risk and the same annual earnings butwith different capital structures and different market values, then by exploiting arbitragepossibilities, the values of the two panies will bee equalQuestion 15.2What is meant by"exploiting arbitrage possibilities"?The following question is hard and you will not be expected to do this sort of questionEA in the examination. However it is very useful if you really want to understand theessence of the mm modelThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 8CT2-15: WACCQuestion 15.3Suppose we have two panies A and b with the same business risk and annualoperating profit of elm, and the following capital structuresBEquity8% debt4mYou are going to show how arbitrage can make the value of the panies equalMr Jones has f400,000 to invest. Investing in these two panies and borrowing andlending in the risk-free market are the only choices available(i) What will Mr Jones earn if he puts all his savings into Company B?(ii) What will Mr Jones earn if he puts all his savings into Company A?(iii) Company a is ungeared and Company B is geared. The gearing of a portfolio isa measure of its risk, so a portfolio of Company As shares is less risky than aportfolio of Company Bs shares. Mr Jones can increase the riskiness of aportfolio that includes Company A's shares by borrowing iX in the risk-freemarket(which is assumed to be available to both panies and individuals atthe same rate) and using all the available funds (E400, 000+fX)to invest inCompany As shares. Find the value of X that makes the two investmentportfolios equally risky.(iv) For this value of X pare the expected returns from each of the twoinvestment portfolios(v) What will happen to the market prices of the shares in Company A and inCompany B(vi) Assuming that Company B's shares take all the adjustment, how far will themarket price of Company Bs shares fall? ExplainSo, the value of a pany is independent of its financing decisionLet's examine the effect of gearing on the WaCCC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCPage 9Question 15.4Following arbitrage, suppose the two panies a and b ultimately have the samemarket value as shown belowequity10m6n8%debtFind the WACC for each pany, given that the operating profit is flmThe MM model predicts that for panies with the same business risk and the sameearnings, the WACC is the same, regardless of gearingLet us now consider the effect of gearing on the return to equityIn the last question you will have found that the return to equity in Company A is Iand the return to equity in Company B is 11.33%This is the basis of Modigliani and Millers second irrelevance proposition: Theexpected rate of return on the mon stock of a leveraged firm increases inproportion to the debt-equity ratio, expressed in market valuesLeverage is the term used in the US for gearing, so a leveraged firm is a geared firmie one that has some debt finance. Common stock refers to the pany's ordinaryharesWe can see from our answer to Question 15. 4, that the return to equity in Company Bhigher than the return to equity in Company a by just enough to offset the higherproportion of the cheaper debtThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACCThe following graph shows the rates of return on debt and equity for a single panyas its gearing ratio increasesrate ofreturnreturn on equityWACCreturn on debtdebt/equityModigliani and miller argued that the wacc remains constant as gearing increases. Asgearing increases, the cost of equity increases by just enough to offset the increasingproportion of the cheaper debtYou might think that if the expected rate of return is higher for a more highly gearedstructure(such as Company Bs), the value of the pany might increase with gearinHowever, let us examine the pattern of returnsIn Questions 15.3 and 15.4, we assumed an operating profit of flm. What wouldhappen to the rates of return if operating profit were higher, or lower? Supposeoperating profit could be as low as E0. 5m or as high as t2m. The following tables showthe possible returnsCompany AEarnings available for shareholders(Em)0.5102.0Equity(£m)101010Return on equity (%)5%10%Company BEarnings available for shareholders(Em)0.180.681.68Equity(£m)Return on equity(%3%11.33%28%So, although the more highly geared structure offers a higher return on equity, it alsooffers a higher risk. These two features cancel out to leave the price and the value of theshares unchangedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCAdditionally we could argue that increasing the gearing does not give the shareholders apattern of returns that they could not have achieved themselves by borrowing money andbuying more sThis thinking was further developed by the capital Asset Pricing Model (CAPMwhich attempts to provide a coherent framework for understanding thenteraction of risk and return this model will be studied in detail in ct8. We willuse its main conclusions in our further study of waccQuestion 15.5Suppose Growmore plc(see example on page 5p laises a further E50 million of debtfinance in order to buy back shares with a value of t50 millionAccording to MM, what would be the impact on Growmore'S WACC?Later theoriesThe MM theorems are a cornerstone of finance. The subsequent development of thetheory of corporate finance can be described essentially as exploring the consequencesof relaxing the strong MM assumptionsThe effect oftaxInterest payments on corporate debt are tax deductible, so debt finance for firmessentially subsidised by the state, thus making debt finance more attractiveWhilst the original MM paper argued that the cost of capital should not bedependent on the level of gearing adopted by the pany, they subsequentlydeveloped an after-tax formulationThe after -tax version examined the tax advantages of debt finance whereas the initialmodel suggested that the value of the pie is independent of how the pie is split(betweendebt and equity ), the introduction of tax implies that there is a third slice, ie thegovernments slice. The tax system provides a tax shield (ie a reduction in tax)so thatthe value of the geared firm is the value of the ungeared firm plus the tax shield. Thiscould suggest that firms should bee 100% debt financed if we ignore otherconsiderationsHowever, Miller later found that when personal ine taxes as well as corporate taxesare taken into account, the gain from a pany increasing its gearing is reducedeliminated or even negativeThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 12CT2-15: WACCThe effect of different borrowing ratesIf we allow for panies being able to borrow at lower rates of interest theindividuals. then it means that individuals would not be able to replicate the returnsfrom a more highly geared pany by borrowing and buying more shares themselves(as MM assumed). Firms that borrow could be seen as performing a valuable functionfor their investors. (This point is enhanced by the fact that panies receive tax reliefon their borrowings but individuals do notAlso, corporate rates tend to vary inversely with the size of the firmThis implies that the WACC would decrease with increased gearing, particularly forlarge firmsThe effect of restricted debt capacityThe mm analysis assumed that increased debt can be raised at the same cost as beforebut of course the debt is not risk-free. Loan capital providers would reassess therequired return on the panys debt given the new, more highly geared and riskystructure, ie the credit rating of the pany would decreaseExampleSuppose Growmore plc's existing and new debt are likely to trade on a level of(say)10.25% GRY to pensate for the higher risk of default attaching to the pany'sdebt. The equity holders have also increased their required return(to 14%)to reflect thediscussed above). Then the cost of capital for the pany would e. ared pany(aseater risk of default and the greater volatility of the highly gea150×10.25%+50×14WACC=11.2200ie higher than beforeTherefore, in practice, an increase in gearing, beyond the pany's debt capacity,could increase the pany's wacCEffect of other assumptionsWork on relaxing other assumptions is beyond the requirements of the Ct2 courseC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCConclusionPutting the above arguments together suggests that increasing the level of debt in thebusiness will initially reduce the WaCC as the pany takes advantage of the lowercost of debt and the tax relief on debt finance. however as debt finance increases bothequity holders and debt holders will require a higher rate of return. There will be a pointat which the costs of increasing the gearing begin to outweigh the benefits and theWACC begins to increase, ie there will be an optimal capital structureACC (%)minimum WaccstructureIn 1998, Myers suggested that although an optimal capital structure does exist, thereno golden rule: the optimum varies from firm to firm and from industry to industry. Wehall study capital structure in more detail in Chapter 16We shall now study the cost of equity and the cost of debt separately in Sections 2 and 3and subsequently put them together in the WACC in Section 4The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACCCost of equity2.1 IntroductionThe cost of equity represents the opportunity cost of capital the rate foregoneby shareholders investing in the project rather than investing in alternativesecuritiRisk and returnIt seems reasonable that the market should reward the additional risk beingtaken by the equity holders. There are investors who enjoy the gamble andopportunity to make money by beating the odds so there is no guarantee that allprefer a steady return and price to a volatile oneWhat is certain is that there are many investors who are effectively excludedfrom investment in equities because they cannot afford much in the way of adownside potential. So one would expect a premium on equities due to supplyand demand considerationsQuestion 15.6Discuss the following two statementsCompany A and Company B are identical panies except for the fact thatonly people with surnames that begin with an 'Mcan hold the shares ofInCompany b to fall below those of Company A. The expected return from sharesin Company B will be higher than from those of Company Alany investors shy away from equity investment because the risks involvetoo high, therefore the expected return from equities is higher than thatdelFormulaThe conventional approach to the cost of equity is to state it asCost of Equity Risk-free rate Equity risk premiumThe risk-free rate can be regarded as the return required from a risk-free asset such as agovernment bond. Government bonds are often known as gilt-edged securities orgiltsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCThe equity risk premium is the additional reward required by equity holders to cover theadditional risk of holding shares rather than risk-free bondsEvidenceAn obvious starting point would be to look back at historic rates of return onsecurities. In practice it is usual to use market indices, or bundles ofrepresentative securities, for this purposeChoice of the historical periodIt is a matter of record that equities have performed better than fixed interestinvestments over any sufficiently long-term period This is true of many stockmarkets worldwide. However, there is considerable volatility in price levels andon an inflation-adjusted basis there have been occasions where if one bought ata peak, it has taken 15 years for the equity portfolio to have got back to the samepositionIn respect of past performance, most mentators would suggest that datataken from as long a period as possible should be used, provided that it isadequately homogenous. Clearly, if the nature of the constituents within theportfolio being analysed have changed substantially, then some sub-set of thedata might be more appropriate.Over much of the early 1990s, the return on long bonds almost matched that of equitiesin many markets. This was caused by a reduction in the perceived threat of inflationIt should be borne in mind that the performance of equities over the last two decades hasbeen partly due to a re-rating as opposed to simply the sum of the dividend yield and thedividend growth that has been achieved over the period. It is true that the dividend yieldplus dividend growth would still have been higher than the yield on bonds over thperiod, but equity prices now trade on between 30 and 50 times their dividend paredto 20 times their dividend in the early eighties. This has been a major contributor to theperformance over the periodIt may be possible to enhance the data available by using results taken morefrequently, eg monthly rather than annual returns. However, it is important tointerpret such data with care in order to eliminate explicit bias (such as seasonalelements)as well as statistical factors(such as the measure of volatilityThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACCReal and nominal ratesOne source of heterogeneity can be removed if real, rather than nominal, ratesare analysed. Thus while the risk-free rate can be defined on a nominal basis(inwhich case one might use a conventional fixed-interest gilt rate of a term similarin length to the project), alternatively one can work using real returns, in whichcase the yield on index linked gilts can be usedHowever, removing the actual inflation experienced will not address the issue ofthe inflation risk premium contained in the rates observed Remember that theinflation risk premium is the additional return required by investors as pensation foran uncertain inflation rate. For this reason, it is probably more appropriate todepose the historical data into two elements the risk-free rate(usuallytaken as the return on Treasury Bills or other short-term government loans )andthe risk premium( the additional return provided by the security or index underconsideration). By establishing the average risk premium from historic data, wecan estimate the future required opportunity cost as being the current (orexpected)risk-free rate plus the expected (average) risk premium. Even so,many practitioners would adjust the risk premium to reflect their views about therelevance of past experience to future conditionsClearly, the choice of a real, rather than a nominal, rate will need to be reflectedin the nature of the cashflows projected for discounting. Real cashflows shouldbe discounted at a rea rate of return while nomina cashflows will need anominal rate for discounting.We shall assume here that we are concerned with the determination of a realdiscount rate which is to be used in conjunction with cashflows determined onthe basis of present day money values excluding the effects of future priceinflation For some purposes, however, notably when the financing of theproject is being considered it may be more appropriate to allow for future priceinflation in the cashflows and(where appropriate) in the financing payments. Inthis case a nominal discount rate equal to the real rate pounded with theassumed average rate of price inflation should be used. this may give adifferent result if some of the cashflows would not increase with price inflationTypical resultsOne of the most accessible studies in the UK is the Barclays Capital Equity-Giltstudy. Looking at dividend yield and growth, this study calculates the historicreturn on equity as 5% real. Assuming a risk-free real rate of around 2%, thissuggests an equity risk premium of 2-4%C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCPage 17These numbers convey a precision that is inappropriate for by choosingalternative methods it is possible to arrive at a return on equity of as much as10-11% real. The calculation of 5% referred to above was based on a periodfrom 1899 to the present and it effectively looked at the growth of an indexassuming reinvestment of dividends over that period and adjusted for inflationIf one had simply calculated the average return, investing f1 each year andaveraging the result, then the apparent return of equities would be higher. thereason for this is a direct result of the volatility of equities as in an index fund ifthe market halves then only half the amount is available for investment thefollowing year. Mathematically, the long- term index return is like a geometricmean and the average annual return like an arithmetic mean. Everymathematician knows the result that the arithmetic mean will always be greaterthan the geometric meanThe above discussion is to warn the reader off any attempt for extreme accuracywhere risk and uncertainty are involved. It is more important to grasp theprinciples than to follow a mathematical formula. At the end of the day thediscount rate we use will only need to be roughly right as its main purpose is tohelp rank projects and not to price them exactly As in all actuarial work, it willbe consistency of approach and application of judgement that are of primeimportance.2.2 The capital asset pricing model(CAPM)and riskRisk and volatilityNext it is necessary to pare the individual pany and the market indicesfrom which the historic returns were puted.We need to find the cost of equity for a particular pany. This cost prises thetwo parts: the risk-free return and the equity risk premium for this particular panyWe want to find out what return the shareholders of a particular pany require. Thiswill be related to the risk they perceive in the pany's sharesA market portfolio of equities suffers a relatively high degree of volatility. thestandard deviation of annual returns of the uK stock market on a real basis isaround 20%. It is equally clear from one day' s observation of the stock marketthat not all shares move in the same direction at the same time and to the samedegreeAs is well known, diversification reduces risk. Specifically, the variance ( orstandard deviation of the returns experienced by individual stocks are differentthe fact that the individual stock returns are, typically, not perfectly correlate ofto(and usually greater than) the market as a whole this is a consequenceThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACCThus the portfolio variance is given by:XixiPjojowhere xi, x are the proportions of stock i and j held, O and o are thestandard deviations of stock returns and Pi is the correlation coefficientbetween the returns on stocks i and j. This formula gives the variance of a sum ofcorrelated random variablesThis begs the question as to what the performance volatility of an individualshare is pared to the market averageThe CAPM provides a coherent theoretical framework for examining this issueThe CAPM is only valid within a special set of assumptions. These include thefollowinginvestors are rational (they aim to maximise expected satisfaction) and risk-averse(they would reject a fair gambleinvestors can borrow or lend unlimited amounts of a risk-free assetconstant risk -free ratethe market is efficient (lots of buyers and sellers, perfect information etc)the volatility of returns is a good measure of riskAlthough these(and other )assumptions are rarely met, CAPM is one of the mostfrequently used models of risk and returnThe CAPM divides the volatility of a stock's price into two parts, the specific riskand the systematic risk.Specific riskThe meaning of specific risk can best be described using an example. A pany is inthe business of property development on greenfield sites (tutt, tutt). Each projectinvolves estimating the market value of the finished property, estimating the costsinvolved in constructing the property and tendering a bid for the project such that thepany achieves an overall return in excess of its weighted average cost of capitalThe pany will be exposed to problems such as labour shortages, land/environmentalproblems and poor project management. On the other hand, there may be some upsiderisks such as good relationships with the town planners helping to smooth the planningC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCThe CAPM assumes that all shareholders hold a large, well-diversified portfolio ofshares. Some panies might suffer downside risks while others benefit from upsiderisks. The specific risk of a portfolio of shares reduces rapidly as the number of sharesin a portfolio increases from one to two to three, etc. Eventually by the law of largenumbers you will diversify away all the specific risk in the portfolioSpecific risk is risk that can be eliminated by diversificationabout earning a return to pensate for a panys specific risk efore be concernedShareholders who hold a diverse portfolio of shares will not therefore be concernedSystematic risk.If shareholders hold a fully diversified portfolio of shares, they can remove all of thespecific risk. However each pany is still exposed to a high degree of systematicrisk. Systematic risk would be the risk of being fully exposed to the economy ingeneral. Many events can affect the market as a whole, such as movements in interestrates, inflation or currency fluctuations, and cannot be diversified away by having manyshares. These events will influence the success of all of the paniesSystematic risk or market risk cannot be diversified awaQuestion 15.7Suppose you are offered the following business deal. You have to throw a fair die aspecified number of times(the number of throws is subject to negotiation). You willreceive (or pay if negative) the difference between 4 and your average score, xie(4-x) times one dollar for each throw of the dice(i) What would be the systematic risk if the project involves throwing the die(a) three times(b) one million times?(i) What would be the specific risk if the project involves throwing the die(a) three times(b) one million times?The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 20CT2-15: WACCIn theory, the specific risk can be diversified away on a large well spreadportfolio leaving the systematic risk, which is the volatility of the individualshare pared to the market as a whole which cannot be eliminated bydiversificationShareholders who hold a diversified portfolio of shares and are considering buying aparticular pany's shares are therefore only interested in earning a return for thatpany's systematic risk. We will now look at systematic risk in more detail2.3stematic riskThere are good reasons why we are left with a considerable degree of systematicrisk. Let us consider the possible sources of systematic riskSources of systematic riskBusiness or trade cycleThere is an underlying cycle of business activity, which will tend to affect allbusinesses at the same time Different business sectors may be hit earlier orlater in the business cycle and so sector diversification is important.Diversification overseas will also help as not all economies move in the samecycle. Even with overseas diversification there is a considerable degree ofsystematic risk because the whole international economy is highlyinterdependent todayInterest ratesInterest rates are a second economic influence that affects all businesses. Theywill affect different businesses to different degrees depending on their level ofborrowing, creating specific risk. International business will be affected indifferent ways as interest rates can vary considerably from country to countrydue to currency uncertainties and the state of the local economyInflationClosely linked to interest rates is the rate of inflation Inflation canpanies in different ways but generally, rising inflation will depressshort-term. However, in the long run price rises restore margins andhave kept pace with inflation No pany can expect to escape the impact ofinflation so it is a systematic riskC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCPage 21Tax, especially changes in tax, can have an impact on price levels and affect alltaxes, eg a sales tax on beer, will affect only those panies selling beer hies, SeThis only appltaxes that homeCurrencCurrency movements will affect all panies trading in the affected countriesto different degreesFreak eventsInternational crises, wars, embargoes can all affect the global economy in a waythat everyone is affectedOne may speculate thatcounties"Tents or man made events could cause majorunpredictable systematicThe tsunami in the Indian ocean in 2004 had amajor impact on someeconomies. Global warming could have amajor economic impactThis list is not exhaustive but it does show that there are strong grounds forsaying that there will be risk in equity prices that is systematic and not specificto individual panies.Question 15.8List 5 more sources of systematic risk for a fully diversified equity investor in the UKmarketBeta as a measure of systematic riskWe have said that shareholders are only interested in earning a return for the systematicrisk, because they will diversify away the specific riskWe have also said that all panies are exposed to systematic risk because they are allexposed to the market. However, some panies are more exposed to the market thanothers and therefore are exposed to a greater proportion of the systematic risk in theThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACCWe can pare individual stocks with the overall market by assessing the beta(B)of the stock.For panywhere o is the variance of the market index and oim the covariance betweenthe individual stock,'s return and that of the marketalternative expression for beta isBi=Pim omwhere Pim is the correlation coefficient between the individual pany's stock returnand that of the market, and o and om are the standard deviations of the panysstock return and the market index respectivelyA value of beta in excess of 1 indicates a stock that has, historically, amplifiedthe return of the whole market (positive or negative). a beta close to zero wouldindicate a stock that provided a more stable return than the market as a whole.A negative beta would signify a stock whose performance was counter cyclicaloffsetting the overall market experience.Thus, beta can be regarded as a measure of the systematic risk associated witha particular stock.If a stock has a beta of 2 in CAPM terminology, then for every percentage pointperformance achieved by the market above the risk-free rate of return, the stock wouldbe expected to achieve 2 percentage points extra return. For every 1% return below thrisk-free rate of return achieved by the market, the stock or portfolio would be expectedto achieve a return of 2 below the risk-free return This stock is more volatile, ie morerisky than the market as a wholeC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCImplications for the cost of equityIf the stockmarket prices risk efficiently, then a stock that has a higher standarddeviation of return (riskier)should be priced to offer a correspondingly higher returnFor each percentage point of extra return achieved by the market above the risk -freerate, the stock would be expected to return B, times that extra returnRemember that thecost ofequity in the market risk-free return t equity risk premiumWe can estimate the cost of equity for a particular pany as beingrf tB(m -+here r is the risk-free rate and('m -rf)is the market risk premiumSo the cost of equity for pany i()万=r+B(m-r7)The key result of the Capital Asset Pricing Model is that for a single stockCost of equity for stock Risk-free rate equity risk premium x Beta for stockNotice that ris sometimes called the market risk premium and sometimes theequity risk premium. Examiners usually call it the equity risk premiumQuestion 15.9If the risk-free rate of return is 3% and the equity risk premium is 5%o, what is the cost(i) Company a with a beta of 1.7(ii) Company B with a beta of 1(iii) Company C with a beta of 0.4?The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 24CT2-15: WACCCAPM states that an investor will require a higher return to invest in a more volatile andrisky stock(B>1) pared to the diversified market portfolioQuestion 15.10If the risk-free rate of return is 5%, the equity risk premium derived from the market7%and Fryday plc, an ungeared pany(which pays no tax), has a beta of 1. 2, whatuld be(i) the expected return from the market(ii) the expected return from shares in the pany(iii) the cost of capital used by the management in evaluating projects?Adjusting beta for gearingThe beta of a pany's shares, and hence the cost of equity, is affected by thepanys existing gearing. If the gearing were to change, then the volatility of returnswould change, and hence the beta would change. In certain situations, we can calculatethe effect of changing the gearing on beta by using the following formulaGeared beta ungeared beta x (1+ debt: equity ratio x(1-tax rate)]This involves a formula relating a "geared" beta with an ungeared betaThe derivation of this formula is not required for Ct2This formula relies on the fact that all debt issued by the pany can be issued at therisk-free rate. This is seldom the case. However, it gives an approximate result where thisis not the caseFurther plications arise when we look further down the tax chain, because the formulaassumes that investors receiving their returns in the form of bond interest or equitydividends apply the same criteria. Of course these two types of ine stream are taxeddifferently in the hands of investors(see Chapter 3), so investors apply different criteriaand require different returns from each type of assetC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCExampleFryday plc is ungeared and has a beta of 1. 2. Assuming a corporation tax rate of 30%,what would the beta of the pany 's equity shares bee if it issued an amount ofdebt equal to 50% of its market capitalisation and used the cash raised to repay half ofthe existing equity shares?Geared equity beta =Ungeared Beta x[1+(Debt: Equity ratio)x(1-t )1.2×[1+(1)0.7]2Question 15.11Calculate Fryday plcs new WACC in a taxed situation, assuming that the newdebt equity ratio is 1: 1 and that the gross cost of debt is 5%Question 15.12Suppose Led plc has debt: equity ratio of 2: 3, a beta of 1. 2 and is taxed at 30%. Howwould the beta change if the debt: equity ratio increased to 3: 2?Notice that the pany's current value of beta incorporates the effect of its currentEk> level of gearing. If the gearing changes, you must find the new beta in two stages:findthe ungeared beta first and then find the new beta for the new level of gearingThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACCMeasuring betaHistorical returnsIf historical returns are available over a number of periods we can definer to be the actual measured returns for stock i, andm to be the market returns over the same periodsTi to be the average of the measured returns of stock ir. to be the average of the measured returns of the marketo to be the estimated standard deviation of the market returnsOim to be the estimated covariance between the returns of stock i and returns of∑(my-m∑[(-)x(m-5)and hence estimateQuestion 15.13Prove that if the price movements of a stock are perfectly positively correlated with themarket and have the same standard deviation as the market, then the expected returnfrom that stock must be equal to the expected return from the market.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCRegressionAlternatively we can estimate Bi by regressing the share's returns against returns on themarket index. The regression fits the best estimate of beta in the model=r+B(m-)Quick methodThe beta measures the"additional return achieved by the market above the risk-freereturn". However in practice, given the imprecise nature of such analyses, the risk-freereturn on a short-term basis(daily or weekly) is set equal to zero. So if, over short timeds, the stock is observed on average to change by 60% of the market's change, it issaid to have a beta of 0.6However, note that estimates of a pany,'s beta, derived from regressing thepany' s stock price performance on that of the market, will vary with theperiod over which the estimation is made. Additionally, an internal estimate forbeta will typically span a wide range of values, due to the high standard errorassociated with the regressionUsing an industry betaOne way of improving the estimate is to use an industry beta based on a groupof similar panies.y " similar"we mean more than that they are all engaged in similar activities, asthe nature of their activities will only affect the business risk of the pany orindustry. Geographic areas of operation will be important, but we also need toensure that they face similar financial risk- that is, that they have similar capitalstructures. Crude values of beta derived from historic observations will benfluenced by financial leverage(or gearing ), and this needs to be allowed for inour calculationsDifferent panies have different levels of gearing. Since gearing affects beta, inestimating its own beta, a pany will need to adjust the industry beta to allow for anydifference in gearing between itself and the industry as a wholeThere is some controversy over the correct value of betas for different sectors. They arenot necessarily stable over time. By the time the observation period is over, the marketthe economic environment and the particular panies being observed have allchanged, so the beta estimated using past data will not necessarily be a good estimate ofthe current or future value of betaThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACC2. 4 Market derived real discount rateAn alternative(approximate) way to calculate the cost of equity is to look at thedividend yield and add this to the forecast future real growth rate of dividendThis is based around the discussion earlier in this course. where we established that aholder of an equity share receives an ine stream and a capital gain caused by growthin the share price. So an investor who paid P for an equity share will receive anannualised return on this investment equal toannual dividend ine expected share price growth per annum=d+gwhere d is the dividend yield and g is the annual rate of growth in share priceWe showed earlier that the price of a share will grow each year in line with the growthin the dividend payable. In other words g will in fact be the annual rate of growth individendsThus the total expected return from investing in a share is the dividend yield plus thegrowth in dividendsIf the market as a whole is made up of many rational investors, then the overall expectedreturn from an equity share(d+g) will be equal to the overall required return by all theinvestors. This is one of the basic functions of the market-to find the equilibrium priceat which investors'required returns are matched by their expected returns.(Presumablyif the expected return was greater than the required return overall, rational investorswould buy the shares until the price rose sufficiently to make the two equal!)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACC3 Cost of debtHaving looked at the cost of equity, we now need to consider the cost of the debtcapital used by the pany, which is the other ponent of the Wacc3. 1 Marginal or average cost?In deciding the relevant cost one needs to assess whether it is the marginal cost(ie the cost of raising further debt)or the average cost (ie the average cost of theexisting plus new debt) that matters. Marginal cost adds new plexity. If newdebt is being raised to help finance a project then it would be reasonable to usethe marginal costQuestion 15.14Discuss the statement: " If new capital is being raised to help finance a project then itwould be reasonable to use the marginal cost3.2 Determinants of the cost of debtThe cost of debt will vary from pany to pany depending on its creditworthiness, often expressed as a credit rating. the cost of debt will be relatedto the credit rating. The lower the credit rating the more the pany will haveto pay for debtWhat do the credit rating and the cost of debt depend on?Interest and asset coverThe debt carrier will look at the security provided and the key ponents ofthis will be the cover provided in the form of net assets to amount at risk andprofits before tax and interest to debt interest. the credit rating agencies willassess risk of default that will depend on the level of interest cover and thevolatility of the profit streamAn investor in debt securities will worry about the pany's ability to repay the nominalamount of the loan at maturity or earlier in the event of a wind-up, and will worry aboutthe pany's ability to pay the interest payments on the debt. These were discussed inChapter 12 where we looked at accounting ratiosThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACCAs a reminder, this risk can be measured by looking attotal assets-current liabilities- intangible assetsAsset coverloan capital +(all prior charges)andprofit on ordinary activities before interest and taxationnone coverannual interest payments due on that issue of loan stock all prior loan stockGearThe marginal cost of debt will increase as the level of debt is pushed up becauseof the adverse effect on the pany's credit ratingBetaThe beta can therefore have a direct effect on the credit rating since a high betawill indicate more volatile profits. The level of gearing itself will increase thebeta. There es a point where taking on further debt increases the averagecost of capital because of these secondary effectsTaxInterest payments on debt capital can usually be offset against profits and serve toreduce the effective cost of debtWe discussed this earlier- the government pays t x(the gross bond ine)on behalfof the panyA new pany may not be in the position of making profits and so is at adisadvantage. In assessing the cost of debt it is necessary to make anassumption as to when profits will e through. a reduced rate of tax deductionto reflect the deferment may be usedThus:Net cost of debt Cost of debt depending on rating of pany x(1-tax rate)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCPage 314 Weighted average cost of capital4.1 The calculation of waccWe shall just recap on the main points derived in this chapterThe Weighted Average Cost of Capital (WACc)is calculated by looking at the mixof debt and equity actually employed and so will result in a value below the cost ofequity. The relevant formula isWeighted Average Cost of Capital(Cost of Equity x equity capital Net Cost of Debt x debt capital)/Total CapitalThe cost of equity is the required return by shareholders when they invest in the equityshares. That iscost of equity= risk-free rate geared beta X equity risk premiumWhen using the formula above it is important to remember the effect of gearing on theriskiness(and hence the required return) from an equity share. The expected returnfrom equity (ie the cost of equity) rises as gearing increases. This reflects the increasedequity of increased gearing, first find the effect on beta by the following formule. cost ofrisk of default and increased volatility of return. To find out the effect on tIgeared beta=ungeared beta X / 1+ gearing x(1-tax rate))and then find the effect on the cost of equityThe net cost of debt is the gross expected return by bondholders that are currentlyholding the bonds- ie the gross redemption yield-adjustedtreatment of debt finance in the corporation tax system. That isnet cost of debt= gross cost of debt x(1-tax rate)Remember that the gross cost of debt depends on the pany's credit ratingThe weighting factors are the market values of the various ponents of capitalThe above formula can be used to estimate the Wacc at different debt: equity ratiosThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACCQuestion 15.15Spire plc has a debt: equity ratio of l: 1. The risk-free rate of return is 4%, the equity riskpremium derived from the market is 6%and the gross cost of debt is 4%. Its beta is 1.5and assume any profit is taxed at 30%( i) Calculate its weighted average cost of capital(ii Spire is concerned about its high debt: equity ratio. If Spire were to repay alldebt, what would be the required return to equity?(iii Spire decides against repaying all debt but instead embarks on a rights issue inorder to reduce its debt: equity ratio from its current position of 1: I to a newposition of 1: 3. Calculate its weighted average cost of capital after the rightsIssueState any assumptions that you make4.2 Uses of wAccWACC is a consideration in the determination of the capital structure of the pan(the financing decision) and in the capital project appraisal process(the investmentdecision)a Examination questions on this topic have, in the past, often asked for calculations (a2 above). These questions are sometimes linked with a discussion of the gearing decision(covered in Chapter 16) since the effect of a change in gearing on the cost of capital isclearly an important consideration in the gearing decision, but not the only one. Moreoften, these questions have been linked with project appraisal(covered in Chapters 17and 18) since the main use of WaCC is as the discount rate in a net present valuecalculationC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCChapter 15 SummaryCost of capitalThe cost of capital is important for both the financing decision and the investmentThe weighted average cost of capital (WACC) is found as followsWACC(cost ofequity equity capital net cost of debt x debt capital)/total capitalModigliani and MillerAccording to Modigliani and Miller's first irrelevance proposition, the market value ofany firm is independent of its capital structure. According to their second irrelevanceproposition, the expected rate of return on the pany's shares increases in proportionto the debt-equity ratio, expressed in market valuesThese propositions are only valid under certain assumptions, in particular in a worldithCAPMThe CAPM offers many useful results, which can be used to evaluate a pany'sWACCThe beta of a pany is a measure of the systematic risk inherent in its profit streamIt reflects the volatility of the pany's share price and how the share price returns arecorrelated with the returns from a fully diversified portfolio(the market). The expectedreturn from a share is related to its volatility(and beta) by the following formulacost ofequity risk-free rate beta x equity risk premiunwhere the beta is appropriate for the equity shares, and allows for the pany's level ofgearingThe tax system rewards the issue of debt and therefore the net cost of debt to a panywill be(1-t)x the gross cost of debtThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACCRiskThe risks of investing in a pany's shares(or a project)can be divided into two typesSpecific riskthe risk that the return from one pany's shares(or oneproject)may differ from the overall expected return from awell-diversified portfolio containing many such shares(ory projects2. Systematic riskthe risk that cannot be eliminated via diversificationC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCChapter 15 SolutionsSolution 15.1The initial cost to the pany of issuing debt is clearly higher than the initial cost ofissuing equity (4% relative to 10%)However the equity shareholders are accepting a greater risk, and must therefore beexpecting a greater return. This greater return must be expected in the form of capitalgrowth through retained earnings and increasing dividends. If the equity investors arepricing the equity correctly(and we should assume that they are)then the dividends willincrease at a sufficient rate that the overall return to equity holders will be greater than10%. Thus the ultimate cost to the pany will be greater than 10%The cost of equity should be greater over the long termSolution 15.2Arbitrage is the buying and selling of financial assets in order to make a profit fromknown pricing anomaliesSolution 15.3(1 Mr Jones could buy 5%of Company B's equity with his f400, 000, and so willearn 5% of Company B's ine after interest payments, ie 5% of E680,000£34,000(ii) Mr Jones could buy 4% of Company A. He would then earn 4% of CompanyA' s Ine,ie4%of£1m=£40,000(ii) To maintain the same risk, Mr Jones would have to gear up to reach the samedebt: equity ratio as Company B, ie 1: 2. Mr Jones could therefore borrowt200, 000 at 8% to put with his f400,000 and therefore buy 6% of Company a(iv) f600,000 of Company As shares would allow Mr Jones to earn f60, 000. Afterpaying interest on his loan of t16,000, he would earn 544,000. A portfolio ofCompany bs shares would earn f34, 000(see(i))The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACC(v) Since he could earn f44, 000 from Company A for the same level of risk as hetakes in earning f34, 000 from Company B, Mr Jones will want to buyCompany As shares. If all other investors are selling Company Bs shares andbuying Company As shares, the market price of Company B's shares will falland/or the market price of Company As shares will rise. The process willcontinue until there are no further opportunities for arbitrage profits(vi) Assuming that Company Bs shares take all the adjustment, Company Bs shareswill fall until they are worth f6mWhy£6mWhen the shares are worth E6m, 5% of Company B's shares will buy only 3% ofCompany A, ie t300,000. To achieve the same level of gearing as Company B,Mr Jones would have to borrow f200, 000 at 8% and hence own 5% of CompanyA. This would give a return of E50,000, and so, after paying interest, he wouldearn f34, 000- the same as he would earn if he held pany b s sharesSolution 15. 4Company A is financed entirely by equity. If ine is flm, and its share capital isf10m, the return to equity is 10%. The WACC is therefore 10%Company b has 60% of its finance in the form of equity and 40% in debtThe return to equity is(flm-t320,000)/6m=11.33%The return to debtholders is 8%So the wacc is0.6×1133%)+(0.4×8%)=10%So the WaCC is the same, regardless of gearingNotice that the return to equity holders in Company B is higher than the return to equityholders in Company a by just enough to offset the higher proportion of the cheaperdebtC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCPage 37Solution 15. 5The obvious conclusion would be that the weighted cost of capital would fall, becausethe pany is now financed by f150 million of 10% debt and f50 million of 12%equityHowever this argument is flawed because the required return of equity investors wouldnot remain constant if the pany structure were changed in this way. The pany isnow much more highly geared and the returns to equity investors are likely to be muchmore volatile. In fact so much more, that the equity investors will require an expectedreturn of 14% in order to hold the shares. The cost of capital is unchanged, being amixture of f150 million of debt capital providers requiring 10% and t50 million ofequity capital providers requiring a return of 14%Solution 15.6"Supply/demand issues will therefore cause the price of the shares in Company B tofall below those of Company AThis statement is clearly false. If the two investments are identical, then any differencein price would cause investors to arbitrage the two panies. This assumes that thereare enough rational investors in the country with surnames that begin withM to holdall the shares which there are"The expected return from shares in Company B will be higher than from those ofCompany a”If the shares in Company B were standing at a price below those of Company A thenthis statement would be correct. However we have discounted the possibility that theshares of Company b would fall below the price of shares in Company A, therefore thestatement is irrelevant in this contextthe expected return from equities is higher that that of debtThis statement is correct. If only a restricted subset of investors can tolerate the risk ofinvesting in equities, then the expected return offered by the investment would have tobe higher to attract the investorsThe reason that Statement 2 is correct is that the supply/demand issues are caused by therisk characteristics of the two investments. If the supply/demand issues are caused onlyby a temporary disruption to the market equilibrium, then there should be no long-termeffect on the ratings of the two paniesThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACCSolution 15.7(i There is no systematic risk in the project, whether it involves three throws of thedice or one million throws(ii) If only three throws of the dice are made there is a specific risk that the projecmay yield a loss. This is a specific risk though, and could be diversified away ifmany such projects were undertaken(or if the die is thrown many times). Thelaw of large numbers guarantees that ultimately the thrower will achieve anaverage result of 3. 5 and an average profit of $0. 5 per throwSolution 15.8There are many possibilities, includingfurther economic integration with the European Unionpolitical upset or turmoilbad winter weather(!)assassinationwarbanking crisisrapid changes in the economic or industrial environmentany sudden change in investors'confidence levelsSolution 15. 9()PA=3%+1.7(5%=11.5%(i)rB=3%+1(5%)=8%(i)re=3%+0.45%)=5%C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCSolution 15 10(1) Market returnrisk-free return equity risk premium5%+7%=12(ii) Equity share return =risk-free return beta x(equity risk premium5%+12×7%0=13.4%(ii) Cost of capital should be 13. 4% as above to meet investors'expectations. Thisof course assumes that no tax is payable, and that a project that yields a return of13. 4% would offer the same return to equity shareholdersSolution 15.11The example has shown that the new beta will be 2.04. The new cost of equity istherefo5%+2.04(7%)=19.28%The net cost of debt will beThus the new Wacc will be2(192893)+12(359)=1139The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-15: WACCSolution 15.12We need to find the ungeared beta first. Using the formulaDBg=puand substituting values12=A×1+1(1-0.3)B4×1.4667→B1=0.8182Therefore the new geared beta is月=0.8182×1+2(1-03)=0.8182×2.051.6773Solution 15 13If the stock and the market are perfectly correlated (Pim =1)and have the samestandard deviation(o,=om), then:Oim= Pi.mO O,Gm=1×G1Xm=O2B1AlternativelyB =P-I and so r='f+Pi(m -rtOC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-15: WACCPage 41Solution 15 14If a pany raises a significant amount of new finance to undertake a project, then theoverall structure of the pany will be altered. It is likely that the overall riskcharacteristics of its earnings will be altered. In this respect the wacc calculated forthe pany before it undertook the expansion will no longer be relevant, and theexpectations of equity investors may change. It is necessary to re-evaluate thepanys WaCC bringing the new risks into accountAs such, the actual cost of raising the new capital might be a useful indicator of the newcost of capital. Investors providing new capital to the pany will focus on the riskcharacteristics of the pany after the expansion. Their expected return will thereforebe consistent with the risks involved in the new expanded pany. The costs of thenew capital will therefore provide an estimate of the pany's new WACC. Forexample, if additional debt is raised, ine cover and asset cover will fall, credit ratingmay fall and the cost of debt could riseIf the project is being financed out of existing capital, we cannot identify a marginal bitthat is being used, so the capital being used costs the same as all the pany's capitalHowever, it may be necessary to use a different WACC. This would depend on whetherthe new project is a departure from the normal profile of the pany. However if thisis not the case. the old wacC can be usedSolution 15.15(1) Spire ple's weighted average cost of capitalSpire plcs cost of equity =risk-free return beta x(equity risk premium)%+(1.5×6%)=13%Spire plc's net cost of debt -gross cost of debt x(1-t)(0.7)=28%Thus Spire plc' S WACC=(0.5×13%)+00.5×2.8%)=79%The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 42CT2-15: WACC(ii) The required return to equity if spire plc were to repay all debtTo find the new required return to equity, we need to find the ungeared betaSince debt can be raised at the risk-free rate, we can use the following formulaDBg=puto find the ungeared beta. Thus1.5=B×1+(1-03)B4×1.7→B4=0.88235Thus the new cost of equity would be4%+(0.88235×6%)=9.29%(ii) The weighted average cost of capital following the rights issueTo find the new required return to equity, we need to find the new geared betaDB8g=A×(1+(=08851-0.3)Thus the new cost of equity will be4%+(1.08823×6%)=10.53%Assuming the net cost of debt remains at 2.8%. then the new wacc can be foundSpire plc’ S WACO=(0.75×10.53%)+0.25×28%)=8.6%C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyPage 1Chapter 16Capital structure and dividend policySyllabus objectives(vi) Discuss the factors to be considered by a pany when deciding on its capitalstructure and dividend policyDeffect that the capital structure used by a pany will have on themarket valuation of the pany2. Describe the effect of taxation on the capital structure used by a pany3. Discuss the principal factors that a pany should consider in setting dividendliDiscuss alternative ways of distributing profits, such as buybacksDiscuss the effect that the dividend policy will have on the market valuation of apan0 IntroductionThis chapter has two main sectionsIn Section 1, we investigate the gearing decision, ie the ratio of debt to equity in thepanys capital structure. This is explored under the following headings:the capital structurehe aims of the financial managerthe assets of the business and their financing needschanges in the capital structuretheoretical background to the gearing decisionfactors affecting the gearing decision in practiceThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 2CT2-16: Capital structure and dividend policyIn section 2 we investigate the dividend decision under the following headingsthe fundamentals of dividend policyother methods of rewarding shareholdersthe market and dividendsIn the past, the examination has tested knowledge of the factors affecting the gearing anddividend decisions; understanding of the implications of a particular gearing or dividenddecision on the market valuation of a pany; and the ability to evaluate theappropriateness of the gearing and dividend decisions of a particular panyCorporation taxAs mentioned in Chapter 3(Taxation), for ease of calculation, we will assume acorporation tax rate of 30% in this chapter, unless otherwise statedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyPage 31 Capital structure1.1 Components of capital structureThe ponents of the capital of a limited pany areequity capitashort and medium-term debtlong-term debtas described in Chapters 2 and 4When we discuss a pany's capital structure, we are mainly concerned with the debtequity decision that the pany takes. The proportion of debt to equity is measured bythe gearing ratio1.2 The aims of the financial managerThe financial managers of a pany seek to maximise the return to the ownersf the equity, within the parameters that the latter set out. These involvethe variability of anticipated returns(having regard to the nature of thebusiness)the owners'desire for immediate profit rather than future high growththe degree to which risk should be carried by the ownersThe management of a pany can control the variability of the profits of thepany by, for exampleincreasing or decreasing the gearing(ratio of debt to equity capital)negotiating clauses in the contracts with suppliers which remove certainrisks from shareholderstaking out insurance against certain risks and the use of export guaranteesother risk management measures including financial risk control andfinancial hedging using derivativesQuestion 16.1Describe how each of the above might affect the expected return to shareholdersThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 4CT2-16: Capital structure and dividend policythe willingness(or otherwise)of the owners to put additional capital intothe businesstheir willingness to see a reduction in the proportion of the businesswhich they ownWhen a pany wishes to raise further capital for expansion, the existingshareholders normally have pre-emptive rights that give them the right toparticipate in the issueThese rights give existing shareholders the opportunity to maintain theirproportional shareholding in the pany, and hence their voting rights and theirdegree of control over the pany. If they do not wish to contribute anyadditional finance, they have two options( i) shareholders can attempt to stop the issue through their existing controlThis is hard to do in medium to large panies because the shares areso diversely owned, and organising any bined action is notoriouslydifficult. Or(ii) shareholders can accept a"dilution"of their holding by selling their nil-paid rights. (See Chapter 6. This means that other investors are able tobuy shares, and the proportion of the pany held by the originalshareholders reduces(although its value should remain the same)Question 16.2Why do regulations require that shareholders have pre-emptive rights?Ya Question 16. 3Greedy AG is quoted on the US Stock Exchange and has raised new finance onnumerous occasions in the last 2 years. Following its announcement that it is to have afurther rights issue, an investor decides that he is no longer willing to mit freshfunds to the pany. Calculate what proportion of the pany he will own and thelue of that holding(assuming no unexpected share price movements) if he doesnothing at all during the rights issue. The details are as followsareRights detailsa one for 2 at $2.50 per shareCurrent holding: investor holds I million shares representing 1% of the panyC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyPage 51.3 Assets and their financing needsAssets of a business can be divided intonon-current assets such as land, property, plant, equipment andintangiblescurrent assets such as inventories, work-in-progress, debtor balancescash(and equivalents)Intangibles are assets that you can't physically lay your hands on, such as copyrights,patents, trademarks and goodwill. These were discussed in Chapter 8The following table gives examples of the sorts of non-current and current assets thatmay be found in the accounts of a typical car dealershipCurrent assetsNon-current AssetsCash registerPetrol purTyres and BatteriesTow vehicleDebtorsLand buildingsCurrent assets are not necessarily short-term -a certain level of these will haveto be permanent for a business to survive. Also, in cyclical businesses currentassets will fluctuate with the cycle in that industry. Thus both non-current andcurrent assets have to be financed on a long-term basis1.4 Changing the capital structureThe need for changeIn most cases, the need for change in capital structure arises from the desire toexpand the business or enter into new or additional capital projects.Another reason for changing capital structure is where the business finds itselfith excess cash that it cannot profitably utilise, and so it returns this toshareholders by way of a share"buybackCompanies may also wish to deliberately pursue a particular level of gearing. Forexample, a pany might raise debt finance to fund a share buyback operation in orderto increase its gearingWe will assume, however, that a pany is raising finance to fund expansionThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 6CT2-16: Capital structure and dividend policyRetained earningsRetained profits are the simplest and most accessible source of finance.HoweverShareholders may demand immediate release of profits as dividendsThere may not be sufficient accumulated funds to finance projects whenrequiredRetained earnings tend to be"slow and steady"in nature, accruing gradually over theyears. The opposite is often true of expansion projects and takeovers, which can be verylumpy"in nature. It can also be the case that the profits of a growing pany areaccounting profits and do not accrue in the form of cash. This can make it difficult touse such profits to finance projectsQuestion 16.4Explain why accounting profits for a financial year might not equate to the increase inthe cash balancequity financeDue to the cost, delay and unpopularity of raising new equity finance(particularly for paratively small sums),other forms of finance are typicallyused -at least initiallyOther forms of financeMost businesses can choose alternatives such as borrowing, lease of assetssale and leaseback or the use of trade credit to finance turnover. (Sale andleaseback is where the owner of an asset sells it to an institutional investor whothen leases it back to the original owner In this way the owner releases thecapital tied up in the asset.However, these alternative financing solutions have their draw backs. Leasedassets may bee of lower value than expected before the expiry of the lease(due to innovation or a change in business strategy)Sale and leaseback forgoes flexibility and the possible future appreciation in thevalue of the property.Borrowing to finance projects is, therefore, typically requiredC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyPage 7ExampleWrongTurn Ltd owns a prime property in the centre of london which it uses as officespace and to house its distribution activities. The building is larger than it requires andit has leased part of the building out to another tenantIn order to repay all of its debt, the management decides to arrange a sale and leasebackwith a bank, under which the bank accepts to buy the building at a 20% discount to thecurrent market value, and in return the pany will pay a rent which is 20%less thanthe current market rent for such office spaceAfter 5 years the pany reviews the decision and findsthe value of the building has risen by 70%(ii the pany has expanded and requires extra space. Unfortunately it can nolonger remove the other tenant from the building. It may have to considermoving to a different location and losing the benefit of the sub-market rent(iii) It has surplus cash in the balance sheet, which is earning money market rates ofinterest. It would like to invest this in the business if it could find the floorspace.The moral is that the decision whether to buy an asset or lease an asset can have veryreal implications for a pany and should not be taken lightlyarguments for both routes, and often considerable pressure on the pany to adopt oneapproach. Only with hindsight is it possible to determine which approach was correctThe use of these alternative forms of finance is constrained by:the nature of the business and its assetthe degree of gearing considered acceptablethe effects of taxationand these are reflected in the credit-worthiness rating of the businessThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 8CT2-16: Capital structure and dividend policy1.5 Theoretical background to the gearing decisionIn Chapter 15 we discussed the theories of Modigliani and millerQuestion 16.5What do these theories say about the effect of capital structure on(i) the market value of a pany(ii) the WaCC?If gearing were pletely irrelevant as the MM theories suggest, we would see thatgearing ratios varied randomly between industries and between firms within industriesYet we dont see this. We find, for example, that particular industries are highly gearedwhile others are lowly geared. This suggests that gearing is importantpanies adjust their gearing until it is appropriate. According to Myers, there is anoptimal capital structure but there is no golden rule: the optimal capital structure mightbe different for different industries and for different firms within an industrySo how can an optimal capital structure be explained? The determinants of the gearingdecision lie mainly in the assumptions of the MM theoryQuestion 16.6Modigliani and Miller made a number of assumptions. The following were the mostImportant:there are no taxesindividuals can borrow at the same rate as paniesdebt is risk-freeWhat are the implications of relaxing each of these assumptions?If you cannot remember the discussion of the mm theory and the relaxation of itsassumptions, refer back to Section I of Chapter 15. You will notice that some of theother assumptions of the model are relaxed and therefore put forward as determinants ofthe gearing decision in the discussion belowC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyPage 91.6 Factors affecting the gearing decision in practiceThe nature of the business and its assetsSome businesses- for example, banks and property panies- will use a highproportion of debt financing due to the nature of their assets(loans, leasedproperties). Others for example mineral prospectors or IT developers - willhave very limited tangible assets and will need to rely on equity finance. Mostbusinesses, however. lie between these two extremesIn the case of high-risk businesses or businesses with very little asset backing (likeadvertising agencies), banks are often unwilling to accept the types of risk involved inthe pany. An IT pany for example may not be able to provide the long-termguarantees required by the bank to enable the bank to provide the finance, at least on theterms the pany is willing to pay. Many panies have very little in the way ofphysical assets to pledge as collateral for the loan (management consultants forexample). Their assets tend to be in the form of human capital. In such cases the termsof the loan may be prohibitively expensive for the pany to bearFinancial riskAs a business expands its gearing the ratio of debt to equity the costs offinancial failure rise. In the end, losses can wipe out not merely the assetsfinanced by the loans, but also those financed by the equity, at which point thebusiness is bankruptThis must be balanced against the higher expected return for the shareholdersConsider the following two scenarios for a property pany, Company X(figures in f millions)Scenario lScenario 2opertyTotalLiabilitiesLoan stockTotalThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-16: Capital structure and dividend policyScenario 1 shows a geared pany that has raised f2 million from shareholders and afurther f9 million in the form of debt. It has used these funds to buy assets worthfll million. Scenario 2 differs from Scenario l only in the amount that the panyhas borrowed in the form of debtUnder Scenario 1, it would require a f2 million(or 20%)devaluation of property towipe out the value of the investment of the equity investors. In other words, if the valueof property fell by 20%0, the property and cash assets that the pany owns would beworth t9 million, which is just sufficient to pay the bondholdersIn Scenario 2 only a 10% drop in the value of the property portfolio is needed to wipeout all of the equity investors'valueThe potential reward for investors is greater under Scenario 2 because equityshareholders gain more for each percentage point that the property portfolio increases inue. They will also gain from fact that the financing cost of debt will be lower thanthe return the pany is generating on its assets, so even if property prices do not riseequity shareholders will get a higher return. However most investors would require agreater prospective return from their investment to warrant taking the increased risk ofScenario 2. As such, the price they would be willing to pay for the equity may well needto be lower- ie the price of the equity could fall in the secondary marketThe greater the debt, the less likely it is that the available assets (possiblyrealised in "distress"circumstances) will be able to pay off all the creditors infull. In addition the holders of the equity will bee concerned that, shouldthe business hit a bad patch, the interest burden will be such as to leave nothingfor themThe cost of debt and equityDebt finance is cheaper than equity finance because debtholders bear a lower risk thanshareholders. Also interest on debt finance is tax deductible whereas dividend paymentsare not. However, as gearing increases, the cost of both debt and equity increases as therisk increases to both lenders and shareholdersThus lenders will wish to consider the existing burden of debt before providingfurther funds. Credit rating agencies monitor the financial status of majorpanies (and others, on request. the down- rating of a pany can have amajor impact on the cost of its existing debt and its ability to borrow moreC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyCompanies have rolling overdraft facilities and short-term finance agreements withbanks that are often specifically linked to the pany's published credit rating(Standard poors, Moody's or Fitch IBCA are among the largest rating panies)Thus. a down-rating can have an immediate effect on the cost of borrowing moreobviously, when a pany rolls over its medium and long-term loans, the interest rateit will need to pay to attract investors will be directly affected by investors'perceptionof its long-term credit worthiness. Many investors are happy to let the credit ratingagencies do this work for them, and accept their judgementCompanies often refer to the risk to their business caused by such a down-rating asreputation riskAvailability of financeThis is very much linked with the last point. The pany may wish to raise aparticular form of finance but the providers of debt or equity might be unwilling toprovide it(or perhaps are only willing to provide it at very high rates of return)For example, if a particular project is large in parison to the business as a whole, thelender may not be prepared to lend the amount of capital required, and may wish to addcovenants to the loan agreement restricting the amount of further debt the pany canraIseQuestion 16.7Explain why a bank might be unwilling to finance the whole of a project, despite thefact that it considers the project to be profitable and secureWhere the providers are institutions, rather than individuals, there may be rulesrestricting investment in panies with high levels of gearingControl of the businessShareholders may not wish to see their control in the business diluted by increases inity. In this case, they could either takes offered. or, if they did notwish to or could not afford to take up any new rights, they could try to persuade theto raise the funds in an alternativeIt is thought thatight change withas debt increaseprojects. Agency costs, ie costs of monitoring management, might rise steeply beyond aertain level of gearingThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 12CT2-16: Capital structure and dividend policyThe market viewThe stock market will consider every aspect of a pany in making theassessment of worth that culminates in a share price. If the capital structuredoes not appear consistent with the other features of that assessment, the pricewill change to take that into accountFor example:A high-growth pany that is highly gearedConsider a medium-sized pany in an industry with numerous growthopportunities that is already highly geared pared with its rivals. The valueof shares may be diminished by the market' s expectations that the shareholderswill be asked to put up more funds. In a static or low-growth industry theconverse will apply since a highly geared pany is making more efficient useof the shareholders' fundsIt is argued that high-growth panies need financial slack, ie a cushion of equity,enabling them to raise more debt finance easily when investment opportunities presentthemselves. High-growth panies therefore tend to be lowly gearedTaking our property pany( Company X)from the example on page 9 there are threepossible outes following the increase in borrowing as the pany moves fromScenario 1 to Scenario 2. One of the following may occur(1) Adding further debt to the pany's financial structure is likely to reduce thee cover of the existing debt. (We defined ine cover in Chapter 12.)Investors could bee worried that the pany may soon be forced to e tothe market to raise more equity finance, because it can no longer finance theinterest burden of the new debt. Any increase in the supply of equity woulddepress the current value of the existing equity(i Equity shareholders may bee worried about the prospective volatility ofmarket prices of property and their effect on the residual value of the panyDue to fears that the chances of a 10% down-valuation in property prices(ie sufficient under Scenario 2 to bankrupt the pany) are quite high, the valuef the equity might fallC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policy(ii) Provided the property market was predicted to be quite stable investors might bequite glad of the additional gearing. The equity shareholders will receive betterreturns from a slow and steady increase in property values under Scenario 2The addition of debt will also make the structure of the pany more taxefficient and offer higher returns to equity shareholders( this is discussed later inthe chapter). Therefore the equity shares may appreciate in value because thenew structure is better suited to the investors' desired risk profileA cyclical industryThe most efficient pany will have a high debt to equity ratio when activity isat its peak, but will be so structured that this debt can be reduced greatly as thetrough approaches. In a downturn, activity will reduce and the pany will needless capital. Profits and therefore ine cover will fall, so it is desirable to reduce debtfinance. Here it is the term structure of the loan capital that will influence thevaluation of the equity.An industry facing declineIn an industry facing decline, the management will need to diversify or go out ofbusiness. If diversification is preferred, the pany will be capital-hungry andwill also need to adapt its capital structure to that of the industry to which it isseeking to move while reducing(by liquidation, if necessary) exposure to thebusiness in decline. If closure of the pany is chosen then the less debt inthe capital structure the betterOften declining industries can be used as"cash cows"to finance the diversification intonewer areas, reducing the requirement to raise further capital elsewhere. Because themanagement has no desire to channel profits into further investment in the old industrthey can take profits as cash and use them for investment elsewherepeople” businessesConsider the case of so called"people"businesses, where the skills and abilities ofcertain groups of staff and management are in very short supply and areessential to the petitive success of the business. It may be necessary toreward some individuals by stock options or other similar schemes. However,excessive use of such arrangements can have an adverse effect on the valuationof the pany's sharesThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 14CT2-16: Capital structure and dividend policyShare options, for example, can have a very dilutive effect on the panys earningsThe directors or management of the pany are given the right to buy shares in thepany at prices which might be well below the current market price-however thevalue of these options need not be reflected in the pany's balance sheet. Whenthese options are exercised, the money paid to the pany per share can be quite low.but a normal share is created. The pany's earnings are therefore divided between anever-increasing number of shares, reducing the earnings per share growthExampleMicrosoft issued share options worth billions of dollars to staff none of which showedup on the balance sheetQuestion 16.8Why might investors be concerned about the market value of outstanding share optionsn a panyCompanies in high-growth but high-risk industriesSome panies operate in high-growth but high-risk industries such as biotechnology or deep-sea oil exploration. Loan capital will not be available, butshareholders will need to be rewarded for the risks they must bear in theabsence of cashflow to fund dividendsConclusionThe more a pany's capital structure fits the market perception of thepany's prospects, the higher the shares will be rated there are no simplerules of thumb -everything in the market's knowledge of the business and itsmanagers will contributeNotice that here we allow for information asymmetries. The managers will know moreabout the pany than its shareholders. The market price of the shares will depend onthe signals received by the shareholders about the pany from the managersThis concern about the market reaction can affect management's decision making.Anissue of debt is often seen by the market as a sign of confidence on the part ofmanagement, whereas an issue of equity is often thought to indicate that shares areovervalued. This has led Myers to believe that there is a preferred pecking orderpanies are likely to choose internal finance first, then debt, and finally equityC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyTaxationThe main features of pany taxation (as discussed in Chapter 3)imply that:o Interest payments are tax deductible, so the tax payable is consequentlyreduced(ii) Writing-down allowances on new plant and equipment are deductible. Inother words panies can reduce their tax liability in respect of the capitalallowances on the plant and equipment they own. The amount and the structureof these allowances will influence a pany's desire to invest in suchequipment, which will influence their requirement for more finance(ii Lease of plant and equipment receives tax relief. As above the amount ofrelief available will influence a panys financing decisions(v) Property rentals receive full relief and industrial buildings have writing-down allowances(although at a much lower rate than plantThis means that the cost of the risk borne by shareholders arising from theirpany' s debt is diminished by the reduction in corporation tax, whereasprofits attributable to shareholders funds do not benefit from such relief.If a pany borrows in the form of debt and buys assets that generate profits, theequity shareholders will benefit fromhe fact that the payments of debt interest serve to reduce the tax liabilitythe fact that the assets themselves attract allowances which can reduce the taxliabilityIn effect, the taxpayer is subsidising the use of debt in the capital structureIn addition, where a pany is owned by taxpaying individuals, theseindividuals may not be able to obtain tax relief on their own borrowings. Thussuch panies cannot expect their shareholders to borrow in order to providethe pany with extra equity capital (other things being equal)Question 16.9What is meant by"individuals may not be able to obtain tax relief on their borrowings"?The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-16: Capital structure and dividend policy1.7 An illustrationWe can demonstrate some of the above conceptsthe ine statement ofWrongTurn Ltd, a pany in a stable, low-growth industry. The pany hasinvestigated a potential project it would like to undertake. It requires t5 million ofadditional capitalEstimated ine statement for Wrong Turn Ltd for the year ended 3/ December 2007(figures in t)Operating profit1,000,000Interest payable on loan stock(E5 million(@ 10%) (500,000)Profit before tax500.000Tax@ 30%(150,000Profit after tax(Earnings)350,000earThe pany made dividend payments of f196,000, ie 14p per share on 1.4 millionshares, in respect of the year ending 31 December 2007.crease in retained earnings154,000The following analysis makes use of some accounting and investment ratios that youmet in Chapters 12 and 13. It might be quite obvious what these ratios represent, but ifnot, remind yourself of them by revisiting the relevant sections in these chaptersIf the shares currently stand in the market at a price of f2 per share and the dividendthe only dividend paid during the year we can findnet dividend yieldnet dividend per shareShare priceThe return on equity capital for the shareholders(using market capitalisation as a proxyfor share capital and reserves )isearnings attributable to equity shareholdersmarket value of equity shares350,0001,400,000×2C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyPage 17where the market value (or market capitalisation) of the equity sharesnumber of equity share x share price(7% is the return in the form of immediate dividend yield and the remainder(of the12. 5%)is in the form of dividend growth through retained earnings.The pany estimates that the project will give a return of 12% on the capital raisedie on t5 million of capital invested, it would yield f600, 000 per year. However, thiscould be as low as a 2% return(t100, 000)or as high as a 22% return(fl, 100,000)Scenario 1gTurn could raise the capital through an additional tranche of the loan stock% Assuming additional ine of E600,000 the ine account for the ingyear might then look as follows:(figures in f)Operating profit1.600.000Interest payable on loan stock(f10 million@ 10%)(1, 000,000)Profit before tax600.000Tax(@ 30%(180000Profit after tax(Earnings)420.000Earnings per shareshares, in respect of the year ending 3 1 December 20 e 14p per share on 1.4 millionThe pany made dividend payments of t196, 000Increase in retained earnings244,000have made a small leap of faith here in assuming that the pany could issue munsecured loan on the same terms as the existing debt, ie at 10% Gross redemptionYield (GRY). In the real world a further issue would doubtless reduce the creditworthiness of the loan and lead to an increase in the gry of the entire issue, includingthe new trancheThis analysis also assumes that the equity share price does not move in response to theexPansionThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 18CT2-16: Capital structure and dividend policyQuestion 16.10Repeat these calculations for the situation in which the ine from the project isf100,000and£1,100,000QQuestion 16.11If WrongTurn Ltd were to follow this route (Scenario 1), give three possible effects oninvestors'attitudes towards the shares, and explain what might happen to the share priceunder each scenarioScenario 2Alternatively WrongTurn could raise the finance through an issue of equity. Assumingthey were sold at the current price of f2 per share(though it would be more usual toissue new shares at a price below the current market price), t5 million would require theissue of an additional 2. 5 million shares(figures in£)Operating profit1.600.000Interest payable on loan stock(E5 million@ 10%) (500,000)Profit before tax100.000Tax@ 30%(330.000)Profit after tax(Earnings770.000Earnings per share19.74pThe pany made dividend payments of f546,000, ie 14p per share on 3. 9 millionshares, in respect of the year ending 31 December 2007Increase in retained earnings244.000Again this analysis assumes that the share price does not move in response to theexpansionComparing Scenario 2 with Scenario 1, we can see that Wrong Turn has paid f150,000more in tax on its profits, simply because of the way in which it has chosen to financethe expansionC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyQuestion 16.12Repeat these calculations for the situation in which the ine from the project£100,000and£600,000Compare your answers with those obtained in gestion 16.10. What do you conclude?Question 16.13Give three possible scenarios for the share price if Wrong Turn Ltd were to take thisroute(Scenario 2), and give a justification of each oneThere is therefore a powerful tax incentive for a pany to borrow ( or take outa lease, etc)when it needs capital for expansion. But the costs of some partialfailure of the business can exceed the tax benefit that has been obtained inrespect of the project and its financing. The greater the debt of a business theless likely it is that the available assets (sold in"distress"circumstances) will beable to pay off all the creditors in full if the business fails. (Remember theexample of the property pany, Company X on page eDThus as a business expands its gearing, the costs of financial failure rise.Financial managers of a pany can use as a yardstick the maximisation of the(positive) gap between tax benefit and the distress cost of failed projects.This could be measured by the change in shareholder value. So for example in the caseof Wrong Turn above, an estimate might be made of the effect on the share price underboth the scenarios. Whichever is most likely to lead to a higher share price, is bydefinition the option which shareholders feel happiest with. Shareholders may prefer anissue of more debt because of the utilisation of the tax benefit and the highgher prospreturn to shareholders of the geared strategy. Alternatively, the preferred route forshareholders might involve the issue of shares because, despite the lower prospectivereturn and tax disadvantages, the feel-good factor of the lower gearing and the reducedvolatility of earnings may be more appealing in the current circumstancesThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 20CT2-16: Capital structure and dividend policyQuestion 16.14Bearing in mind all the points discussed in this chapter, list the main factors that help todetermine the proportions of finance raised by debt and equityThis type of question has been popular with examiners, usually applied to a particularscenario. There have also been questions that concentrate on a particular aspect ofcapital structure, such as the tax implications of a particular source of finance or theeffect of the capital structure on the share priceFactors influencing the gearing decision areasset structure of the businessfinancial riskcost of raising and servicing the capitalavailability of debt and equity financeeffect on control of the panymarket viewtaxationC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyPage 212 Dividends -the shareholders, reward2.1 Fundamentals of dividend policyDividends can be seen as a financing decision- money paid out by way ofdividend is no longer available for investment in the business. This isparticularly true of unlisted panies since:the pany does not have the option of raising further funds in thestock marketthe borrowing powers of unlisted panies tend to be more restrictedOn the other hand, shareholders in such panies have the converse problemthey cannot sell some shares in the market to replace dividend ine.In general, the choice for a pany's board (and its shareholders) is betweenimmediate ine and the prospect of higher ine at some future date. thelatter will, in a listed pany, be reflected in capital appreciation as the markettakes that prospect into account.Factors influencing the decision on dividend policyThe following factors influence the dividend decisionstock marketscash reservesgrowth opportunitiesstability and consistencyStock marketsStock markets display significant adverse reactions to announcements ofdividend cuts. Managers therefore tend to conservatism in good yearsparticularly in cyclical industries and smaller panies (especially those thathave e recently to the market)Question 16.15how could this have a negative effect on a pany's long-term growth prospects ? eThe stock market is often accused of being too focused on the short term If this isThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-16: Capital structure and dividend policyCash reservesCompanies with large cash reserves that fear a takeover bid may well distributegenerously in order to encourage shareholder loyalty and limit the size of thecash pile". There are two principal issues in this decisionA higher dividend may increase the lower support level for the share priceMany stock market analysts pare shares to one another on the basis ofdividend yields. Stock market analysts will find the share relatively moreattractive if the dividend yield is higher.2. In addition, a cash pile is seen by investors as a sign of weakness. Somepanies try to label it as a war chestsh held in anticipation of a largeaggressive takeover bid-in the hope that the market will continue to believethat some big value-adding manoeuvre is imminent. Shareholders invest inompanies to get exposure to a certain type of risk. If they wished to invest it incash or other investments, they would choose to do it themselves through directinvestment, rather than let the pany do it for them. So the thinking is that ifthe pany cant use the money they should give it back to shareholdersShareholders can then find another pany that has some ideas and that can usethe cash! Cash piles are generally perceived poorlyTaxCompanies with a large proportion of non-taxpaying shareholders may feel itappropriate to distribute a large proportion of earningsIn general, non-taxpaying shareholders will wish to receive much of their return in theform of ine, rather than reinvesting the profits in the pany to give a capital gainThese shareholders will be on relatively low ines and thus would like to receivedditional ine in the form of dividends. This will lead to a bias towards highepayouts from panies whose shareholder base contains a higher proportion of nontaxpaying shareholders. Remember from Chapter 3 that under the imputed tax system(as used in the UK)most taxpayers pay no more tax on the dividends they receiveHowever, under this system, higher-rate taxpayers may pay extra tax on the gross valueof their dividend so they might prefer to be rewarded in the form of a capital gainbecause part of any capital gain(up to the capital gains allowance)is tax-freeGrowth opportunitiesCompanies in high-growth industries may find that the demands for capitalinvestment to maintain petitive advantage exceed their capacity to borrowon satisfactory terms and may prefer to pay low dividends rather than makingfrequent rights issues.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyMany internet panies pay no dividend at all, and often have negative net cashflowIt is the promise of superior growth in the future that makes these panies attractive,not a high dividend yield. So paying a dividend to the sort of investor who invests insuch panies makes little senseStability and consistencySince panies with high payout policies tend to attract investors who seekhigh payouts (and similarly for low payout policies and preferences)any movefrom one category to the other will cause adverse market reaction as investorsreadjust their portfoliosQuestion 16.16What sort of investors might have a preference for low payout policies?A change of dividend policy can have significant repercussions for a pany'smarket rating and its capacity to raise finance. We consider the effect of dividendpolicy on the market in Section 2.3Question 16.17Are there any legal constraints on the amount of dividend that can be distributed?2.2 Other methods of rewardIntroductionIn addition to regular dividends, usually paid quarterly or half-yearly, one-offextra or special dividends may be paid occasionallyAlternatives to cash dividends include:scrip, stock or share dividendsshare buybackOccasionally, panies may offer non-cash dividends in the form of productsamples or discounts on services. For example, shareholders of CadburySchweppes plc receive free entry into Cadbury World!The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 24CT2-16: Capital structure and dividend policyOften panies will offer an automatic dividend reinvestment plan. This mayinclude the issue of new shares at a discount to market price (partly to reflectthe saving in underwriting costs). Shareholders are offered the opportunity toreinvest their dividends in the pany 's shares which are offered at a discountWe shall look at scrip dividends and share buybacks in more detail in the following twosectionsScrip or stock dividendsThe effects of scrip issues were discussed in Chapter 6. We also discussed scripdividends briefly in Chapter 6Stock or share dividends are paid in the form of extra shares, rather than cashSuch a dividend will be shown in the pany accounts as a transfer fromretained earnings to equity capitalScrip dividends are defined as either "pure", where the shareholder has no optionto take cash, or as a scrip alternative to a cash dividendIf a shareholder has the right to receive 1 new share for every 20 she holds, this isequivalent to a 5% dividend yield. Some tax issues do arise, since the authoritiesrequire that the value of the new shares allocated are treated as taxable ineEffect on the panThese methods of distribution are of benefit to panies that either have no cash withwhich to pay a dividend because of long-term expansion, or to panies that havetraditionally paid a dividend, but which because of unusual circumstances are unable topay one at present. If they expect to resume paying dividends in the future, and wish thedividend yield to be continuous through these hard times, they may pay a scrip dividendFrom the pany,'s point of view, the scrip dividend retains funds to be usedfor investment or to reduce borrowings and, hence, to improve earnings. Thecapital base will increase and this will improve the pany' s financial capacity.The shareholder base may be increased by the attraction of investors who preferscrip dividendsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyQuestion 16.18A pany is debating whether to pay no dividend or to pay a scrip dividend. Whichoption would you expect to lead to a faster appreciation of the share price over time?Effect on the shareholderFrom the shareholder's point of view there are fewer benefitsTax will normally be payable as if cash had been taken, but this must be fundedout of other resources. the scrip issue only benefits those shareholders whowish to increase their holdings, as they will avoid brokerage and otheracquisition costs and may also benefit from a marginally more favourable priceOn the other hand, the practice considerably plicates the putation andrecording of capital gainsShare buybackIf a pany has accumulated large amounts of unwanted cash, or if it wishesto change its capital structure by replacing equity with debt, it will generallyundertake a share repurchase or buyback exerciseThe procedureThe pany announces that it intends to buy back a certain number of its own sharesThis may be implemented bypurchase of shares in the open market, often by a gradual programmeover a period of timea fixed price offera tender offer (either a Dutch or uniform price auction)repurchase by direct negotiation with a major shareholder.The most mon method is for the pany to announce its intention of buyingshares in the open marketIf the pany repurchases a stated number of shares at a fixed price(typically at asignificantly higher price than the current market value), the shareholders are informedof the pany's intention and are free to accept the offer or not.The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-16: Capital structure and dividend policyIf a uniform price auction is used, the pany asks shareholders how many shares theyare prepared to sell and at what price. For example, shareholder A is willing to sell10,000 shares at f2, shareholder b is willing to sell 15,000 at f3 and shareholder C iswilling to sell 20,000 shares at t4. The pany will then calculate a price at which itcan buy the number of shares it wishes to buy. If it wishes to buy 25, 000 shares, it willpay f3 per share to shareholders a and BIf a Dutch auction is used, the pany states a series of prices at which it is prepared torepurchase shares. Shareholders reply to this offer, informing the pany of howmany shares they are willing to sell at each price. The pany then calculates thelowest price at which it can buy the required number of sharesEffects on the shareholdersOften, for simple supply/demand reasons the share price rises on such an announcementHowever, this is not always the case. Investors invest in a pany with the intentionis essentially forcing some investors to sell their shares and invest elsewhere panyof being exposed to a certain type of risk(and hopefully a certain return). The panySuch an announcement can also be seen as a sign of weakness by investors, who maythink as follows: the pany has no ideas or innovative projects with which it cangenerate a return that lives up to my expectations?!? On the other hand, some mightargue that it is good to reduce the stockpile of cash, since it will not have been earning agreat rate of returnThere are also tax issues to consider. Some investors might be happy to realise a capitalgain if they have not used their capital gains allowance because they will pay no tax onthe capital gain. However other investors may be forced into realising capital gainstimes when they would rather not, for example if their years allowance is already usedup or if they dont have a capital gains allowance, such as UK panies. Sharebuybacks have been a mon way of rewarding shareholders in the United Statebecause, until recently, shareholders had to pay ine tax on dividend ine on topof the corporation tax paid by the pany on its profits. We discussed the treatmentof dividend ine in Chapter 3.Share buybacks can benefit private shareholders to the extent that the taxtreatment of capital gains is more favourable than that of dividends. The effecton the pany' s earnings per share should be beneficial, since the cash heldis probably only earning a deposit rate of interest- much less than its industrialassets. The value of the remaining shares should therefore, improve. However,investing institutions prefer to make their own buy/sell decisions and receive notax benefit from a share buyback, so this alternative is more frequently carriedout by panies with a high proportion of individual shareholders.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policy2. 3 The market and dividendsThe market value of a pany is the market,s valuation of future dividendsunless there are expectations of takeover or winding up and the distribution ofresidual assets).In many cases, such as internet based panies and high-tech stocks, the first prospectof a dividend payment can be many years in the future. Under these circumstances itbees very hard to value panies by this methodIf no outside loan capital is available and the pany has better investmentopportunities than its shareholders, then the payment of dividends will, byreducing the business' ability to take advantage of these situations, bedetrimental to the market value of the pany.Question 16.19Justify this statement using the following scenario. Assume you invest fl million in apany, "PayOut plc". PayOut can earn 14% return on assets before tax and pays taxat the rate of 30% on profits. Assume that the expected net return to you from aninvestment in the stock market as a whole is 7%Test the above hypothesis over a 3-year period by looking at the accumulated value ofyour investment, firstly assuming that PayOut pays no dividend, and secondly assumingthat it pays shareholders 50% of its earnings after tax as a dividendHowever, as long as loan capital is available to the pany on tolerable termsthis restriction does not apply (and even after this is exhausted there is alwaysthe possibility of a rights issue)Looking at the dividend question from the point of view of the shareholder, it isa reasonable assumption that the purchaser of shares takes into account someexpectation of a dividend policy. If this expectation is not fulfilled, it will changethe investor's relative valuation of the shareA consistent dividend policy is, therefore, important in building a clientele ofinvestors, and an unanticipated change can act adversely on perceptions of thepany's worth. It follows that investors will move to shares where dividendpolicy is patible with(or acceptable in) their tax situationThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 28CT2-16: Capital structure and dividend policyqUestion 16.20A large well-established pany has run upon hard times. Having had robust andincreasing profits for the last 10 years, half of which it has paid in the form of dividendsit has been hit by recession in 3 of the 4 industrial areas in which it operates. Thedirectors are keen to maintain investor loyalty, and are afraid of a takeover by anotherompany. However they accept that the profits in the current financial year will be zeroState what further information you would require in order to set the dividend policy forthe ing yearThe financial management of a pany must, therefore, consider carefully thelikely effect on investor perception of any dividend announcement- particularlyif it can be construed as a change in dividend policy. If a change should benecessary, it is imperative that the reasons are well explained in good timeshareholders will generally accept decisions made clearly, in good time and forthe long-term benefit of the shareholders. Any efficient market will take its cuefrom the statements and actions that enter the public domain, not from what apany s managers wish or think.Question 16.21Give three possible courses of action for the management of the pany described inQuestion 16.20 aboveIn the past, examination questions on dividend policy have been quite interesting. For2 example, following a trial balance question involving the construction of an inestatement and a balance sheet, this question was askedComment on the notable features of Z plc's dividend policy. (September 2001)Remember to use your checklists of points to help you generate ideas to answerquestions. In this case, Z plc was paying dividends when it had made a loss in thatIs this allowed? Yes, because the retained earnings exceeded the dividend paymentWhy would the pany do this? The pany might aim for consistency and mightwant to avoid an adverse market reaction. have they the cash? what are theimplications for the pany's liquidity? Could the pany have used the funds in amore useful way, eg reinvested the funds to increase profitability and growth?C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyChapter 16 SummaryCapita/ structureThe management has a great deal of flexibility as to how a panys capital should bestructured. Although the principal aim of the management is to focus on how the assetsof the pany are used to create wealth, it is also important that they manage thecapital structure in a suitable manner. This normally means controlling the amount andmaturity of pany borrowingsAccording to Modigliani and Millers first irrelevance proposition, the market value ofany firm is independent of its capital structure. However, this theory is only valid whencertain assumptions are made. When these assumptions are relaxed, we see the reasonsfor different levels of gearingDebt finance is advantageous in a world with tax. Debt finance costs are deducted frompre-tax profits, thereby reducing the amount of tax payable. In addition, the assetspurchased generate capital allowances, which can serve to reduce the tax liability yetfurtherIncreased debt brings the increased risk of coping with an increase in interest rates,acession, a fall in asset values and winding up the businessAlso, as the level of gearing rises, the service cost of the debt will rise due to the addedrisk of default. The return on equity will no longer benefit from further gearingRaising funds through the issue of equity causes dilution of the existing shareholdersholding in the panyAdditional debt finance may not be available if the pany is already highly geared orhas few tangible assetsUltimately, the market will reflect its view on the capital structure through thepany's share price.The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-16: Capital structure and dividend policyDividend policyKey factors in the dividend decision arestock marketcash(cash rich panies might give a generous dividend or might buy backshares; cash poor panies might give no dividend or perhaps a scrip dividend)growth opportunitiesstability and consistency.Other ways of rewarding shareholders include scrip dividends and share buybacksThe key decisions in a perfect market should be based around the obvious statement thatthe financial managers ofa pany should seek to maximise the return to the ownersof the equity, within the parameters that the latter set outC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyPage 31Chapter 16 SolutionsSolution 16.1Increasing gearingThis would be expected to increase the volatility of the expected return. Because of thebeneficial effect of debt on the pany's tax charge (to be discussed later in thechapter) it would also be expected to increase the return on equitySupplier contract negotiationRemoving risks would be expected to decrease the volatility of the return toshareholders. This can only be done by transferring some of the risks to the suppliersOne would expect there to be a cost involved, which might reduce the return toshareholdersInsuranceAs above, this should reduce the risk and volatility of return experienced byshareholders, but might reduce the absolute expected return to shareholdersRisk management and financial risk controlIf carried out at no cost this should have a beneficial effect on the volatility of profitswithout reducing the expected return. Extra risk through bad risk management does notnecessarily lead to extra returnsSolution 16.2Shareholders have few controls on the managers of their pany in the modern worldEven the ultimate sanction of voting the current management team out of their positionsrequires shareholders to find another management team that can step in. If themanagement were also free to raise capital and give away rights to future profit streamswhenever and to whomsoever they choose, then the amount of control is furtherreIf a pany is successful, the shareholders will want to benefit from that success. Preemptive rights give shareholders the right to maintain a proportional holding of apany in order to benefit from the panys growth. It allows them to maintaintheir voting rights as a proportion of the panyThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 32CT2-16: Capital structure and dividend policySolution 16.3Value of investor's holding before issue =3x1m=$3 millionxpected price of shares after issue =(3x2)+(2.5X1)S2.83 per shareValue of nil-paid rights=2.83-2.5=S0.33If the investor does nothing, the nil-paid rights will be sold on his behalf and he will begiven the sum of 500,000 x 0.33=$166,000 in cashHis holding of shares will be worth $2, 833, 000His proportion of the pany(previously 1%)will fall to1%×(number of shares in issue before rightsin issue after rights)2/3 %of the panySolution 16. 4Accounting profits are concerned only with the overall ine created by a businessduring a year, not the cashflow. This was discussed in Chapter 8. Some of the mostobvious areas where accounting profits and cashflows would differ would be(1) Non-current assets. These would be depreciated through the ine statementover the useful life of the asset. However the cashflow would occur on the daythat the asset is purchased and paid for(ii) Debt. If a pany raises cash by increasing its borrowings it does not treat thicash as a profit. the ine statement is largely unaffected. However suchaction would obviously bring in a lot of cash resourcesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policy(ii) Debtors and other current assets. If a pany sells a product, the profit of thattrade is reflected in the ine statement, whether it is paid for or not. If thepurchaser of the goods has not yet paid, the forthing payment is bookedunder debtors in the current assets category of the balance sheet. The cashflowhowever would not occur until the outstanding debt was settled by the paymentSolution 16.5(1 Modigliani and Miller argued that, under certain assumptions, the market valueof a pany is independent of its capital structure. Their view was that themarket value of a pany is determined primarily by its investment decisionsand not by its financing decisions. This proposition allows plete separationof investment and financing decisions(ii) Modigliani and Miller argued that the WACC is constant as gearing increasesRaising the proportion of debt(which is cheaper than equity) does not reduce apany's WACC because in response to an increase in debt, the cost of equityincreases by just enough to pensate for the increased volatility in earningsand to keep the Wacc constantSolution 16.6If interest payments on corporate debt are tax deductible, this implies that debt financefor firms is essentially subsidised by the state. This implies that the market value of thepany increases with gearing and the WaCC fallsIf firms can borrow more cheaply than individuals, then firms that borrow could beas performing a valuable function for their investors. This implies that the market vaof the pany increases with gearing and the WACC fallsthe cost of debt increases with gearing, this implies that an increase in gearing, beyondthe pany's debt capacity, could decrease the value of the pany and increase thepanys WaCCThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-16: Capital structure and dividend policySolution 16.7a bank will control its credit exposure in a number of ways. It will consider() the amount of each loan as a proportion of its own share capital(ii) the amount of each loan as a proportion of the borrowing pany's sharecapital1 the total amount of all similar loans (ie in the same sector or industry) on thbank's books as a proportion of both of the aboveConstraint (ii) is likely to be the one that bites in the case of this loan because itrepresents a large proportion of the panys businessSolution 16.8The market value of the outstanding options will be approximately equal to(current market value of the shares given away(the amount the directors will have to pay in order to subscribe for those shares)It can be seen that when the directors exercise their options, new shares will be createdThese new shares give the right to participate in the future profits of the pany, andas such have the same value as existing shares. However only the subscription amountwill be received by the pany which may be a lot less than the market value of thoseshares There will be "dilution,' to the extent that the amount received is less than themarket value of the shares issuedSolution 16.9Essentially, when a pany borrows money, it can treat the interest payments on thedebt as a cost in the construction of its ine statement This will reduce thepany's tax liability. If you as an individual borrow money from the bank and investit in some security or asset, you will not be allowed to reduce thaccruing from the asset by the amount of the loan interest payments before calculatingyour tax. Therefore ine and gains are taxable in full, and any loan interest paymentsthat have to be made e out of post-tax earnings. How unfair!C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policySolution 16.1022% returnOperating profit1,100,0002.100.000Interest payable on loan stock(f10 million@ 10%)(1, 000, 000)(1000000Profit before tax100,0001,100,000Tax a 30%(30.000)(330,000Profit after tax(Earnings)70,000770,000Eaarnings per snareThe pany made dividend payments of f196,000, ie 14p per share on 1.4 millionshares, in respect of the year ending 31 December 2007Increase/(decrease) in retained earnings(126,000574.000Solution 16.11Three possible outes are(i The business was already quite highly geared before the additional borrowingWith the additional gearing in the form of the new debt, shareholders maybee concerned about whether or not the pany can continue to service theinterest burden. We are told that the industry is stable but we are not toldwhether the loan has a long, medium or short-term maturity date. What will theinterest rate be when the pany has to repay and refinance the loan? In orderto carry that risk, investors may require a higher prospective return- ie they willbuy the shares at a lower priceis relatively stable with 1th and lofit volatility.Investors may be happy to have the additional gearing. It gives them a higherprospective return immediately (the project adds value)and gives themncreased exposure to any upside risks for the pany.(ii) In the event of a wind-up, the assets of the pany would first be used to repaythe bondholders. Clearly the further gearing reduces the chances of the equitholders receiving anything in these circumstances. Given that this is a largeproject relative to the pany as a whole, the chances of failure must beuppermost in investors minds. If they are concerned about the reduced capitalcover, the equity price may fallThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-16: Capital structure and dividend policySolution 16.122%o return22% returnOperating profit100,0002,100,000Interest payable on loan stock(E5 million@ 10%) (500,000)(500.000)Profit before tax600.0001.600.000Tax a 30%(180.000(480.000)Profit after tax(Earnings420.0001.120.000Earnings per share10.8p28.7pThe pany made dividend payments of f546, 000, ie 14p per share on 3.9 millionshares, in respect of the year ending 3 1 December 2007Increase/(decrease) in retained earnings(126,000574.000The volatility of returns is far greater in the more highly geared situation( Scenario 1)Solution 16.13Three possible outes are(1 The industry is low growth, and the gearing of the pany is reduced under thisscenario. The investors may feel that the pany is not making the best use ofthe capital. Their prospective return has been reduced. This may cause theshares to fall in value(ii The gearing of the pany could have been considered too high in the firstplace. The extra share capital reduces the risk of the pany not being able tofinance its interest payments. This could be perceived as positive and the shareprice would rise(iii) The increased marketability of the shares may be a positive feature, and the shareprice may riseThe additional supply of equity could have a short-term effect on the value of the shaand drive the price down. This would only be a short-term effect, and has little towith the fundamental value of the shares themselvesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyPage 37Solution 16 14You might have included any of the followingAssets. What non-current tangible assets does the business have to support debtfinance?Risk and return. what level of risk are the management and shareholderprepared to take? The higher the gearing the greater the risk(of coping withinterest payments in a recession or a decline in the value of the panys assetsand of low returns to shareholders in the event of a wind-up). Will increaseddebt increase the returns to the shareholders?Cost. Debt finance is cheaper but the cost increases with gearing4. Control. Are the existing shareholders willing to reduce their level of control byallowing more shareholders to share power with them? Will increased gearingaffectosts?5. Availability. Are shareholders prepared to buy more shares? Are creditorse? Relevant factors hepany's current level of gearing, the perceived risk inherent in the parbusiness, the assets of the business, the panys record and its prospectsMarket view. The gearing decision must be appropriate for the business. Forexample, a declining industry should be lowly geared7Tax. Debt finance is more tax-efficientSolution 16.15If the stock market is focused on the short term, it is possible that investors will rewardpanies that pay high dividends with a high share price. Companies will therefore erron the side of returning too much to shareholders, rather than focusing on the payoutratio that best suits their business. This may be bad for the panys long-termThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-16: Capital structure and dividend policySolution 16.16nvestors who may have a preference for panies with low payout ratiosnvestors who prefer capital gains to ine from a tax point of viewinvestors who have no current need for cashnvestors who believe the pany can reinvest the cash better than they caninvestors who are also managers of the pany, and want resources now.Solution 16.17You may remember from Chapter 8 that panies are not allowed to pay out individends more than they have in their retained earnings from the current and previousyears. This is to protect creditors in the event of the pany being wound upSolution 16.18The"no dividend"option allows the pany to retain all of its earnings, and involvesno dilution of earnings (reduction of earning per share) through the issue of new sharesIt would therefore lead to the fastest capital appreciationSolution 16.19Scenario I-the pany retains 100% ofearnings (payout ratio=0%)Suppose the pany has assets of A, and is paying tax at the rate of T on profitsThe value of the assets after n years would be: A(1+(1-T)X0. 14)In the given circumstances, this would be1,000000+0.7×04)£1,323,753(We assume the market value of the investment would rise accordingly.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-16: Capital structure and dividend policyScenario 2-the pany pays half its earnings to shareholders (payout ratio=50%)The retained earnings at the end of one year would beA×(1-7)×0.14The value of assets at the start of the next year would(1-T)×0.14After n years the value of the assets be: 4/ 1+(-T)X0.14The following table shows the retained earnings and dividends rolled up over a threeyear periodTime Assets aiRetained Dividend Dividendstart of year earnings at paid at end rolled upend of year ofyear01000.00049.00049.00056,10011.049.00051.4015140154.9991.100.40153,92053,92053.920154.321Total£165,019The investor's total wealth is 51.154321+i165019=51.319.339The accumulated amount under Scenario l is greater than under Scenario 2This results from the fact that dividends paid out only roll up at 7%o but " retaineddividends" would roll up at 0.7x14%=9.8%The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-16: Capital structure and dividend policySolution 16.20Addition information required includesCan the pany afford to pay a dividend?Are the profits going to recover to their former level, and if so when?Does the authority exist to pay scrip dividends in order to preserve cash?Are other panies in the sector experiencing hard times, and if so, what arethey paying?Solution 16.21Any three of the following will sufficeMaintain the dividend despite the fall in profitsDeclare a scrip dividend equal in size to the previous actual dividendDeclare a postponement of dividend payments until the pany hasrestructured and is profitable againEstimate theable long-term profitability ofachieved in the ing year or two. Scale the previous dividend down to reflectthis lower expectation in the future. This allows investors to gauge the likelylong-term earning capacity of the pany (in the directors'opinion)C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Page 1Chapter 17Capital project appraisal (1Syllabus objectives(vii) Define what is meant by a pany's cost of capital and discuss how its cost ofcapital interacts with the nature of the investment projects it undertakesDiscuss the different methods used for project evaluation3. Describe methods monly used to evaluate risky investments includingprobability trees, simulation and certainty equivalents(x) Show how financial techniques can be used in the assessment of capitalImvestment projects1. Discuss the principal methods that may be used to determine the viability of acapital project0 IntroductionRecall from Chapter I that panies use real assets to carry out projects in order togenerate profits for their shareholders. Indeed, a pany can essentially be thought ofsimply as a collection of projects. Projects can be large or small, and some projects canbe the product of many smaller projects. Before proceeding with a particular projecthowever, it should be thoroughly appraised in order to determine if it is likely to beprofitable and hence worth undertaking. It is the nature of the appraisal of capitalproject that we discuss in this and the following chapterThe Actuarial Education Company@IFE: 2009 ExaminationsPage 2CT2-17: Capital project appraisal (1)In order to acquire the assets to undertake projects the pany must raise financeeither from retained earnings, short-term borrowing or via the issue of long-term capitalThus, the basic requirement of a capital project is that the returns from the projectshould exceed the cost of the capital employed to generate those returns. If this is seemslikely to be the case, then the pany should undertake the project on behalf of itsshareholders, as to do so will add value to their investment. a key element of anyproject appraisal is therefore to assess whether this is in fact likely to be the caseHowever, as the returns from projects are always uncertain, so project appraisal can onlyever indicate the likely profitability of a project and cannot give definite answersThe structure of this chapter is as followSection I first defines exactly what we mean by a capital project and then discussessome of the key concepts underlying capital project appraisalIn Section 2, we consider some of the main methods typically used to evaluate the likelyprofitability of projects in practice. These include discounted cashflow techniques, suchas net present value (NPv) and the internal rate of return (IRR), which might befamiliar to you if you have studied or are studying Subject CTl. In addition a number ofother methods are discussedIn Section 3. we consider how to interpret the result of the numerical evaluation of theproject and how we can gain a fuller understanding of the viability of a project by theuse of simulation techniquesChapter 17 is concerned mainly with the methods of investment appraisal. Chapter 18will consider in more detail two crucial concerns in the investment appraisal process1. calculating the required rate of return for a project ie choosing the discount rated2. how to analyse and deal with risks- including their identification, quantificationand mitigationYou will meet, and use, this material again in Subject CAl, in particular.In the past, the examination has tested knowledge of the different methods of projecta evaluation and the ability to analyse the relative merits of these methodsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Page 31 Introduction to capital project appraisal1.1 Definition of a capital projectBy a capital project we mean any project where there is initial expenditure andthen, once the project es into operation, a stream of revenues less runningcosts. A capital project does not have to involve the construction of a physicalassetThe key feature of a capital project is really that it involves the creation of a new asset orthe transformation of an existing asset into a different asset. In this context asset refersto anything that will generate future positive cashflows for its owner. Capital projectstherefore exclude the transfer of ownership of an existing asset -eg the purchase of anordinary share in an existing panyQuestion 17.1Give three examples of capital projects, as defined aboveNew projects undertaken by a pany requiring significant resources over andabove the normal budget will typically be subject to some form of costjustification to show that benefits exceed costs. But when the costs exceed thebenefits over more than a very short term one quickly needs a mechanism toncorporate the time value of money to consider the value of any project or hoalternative projects pare. Capital will be required to finance these projectsand there will be a cost in supporting that capital. the cost of capital is ameasure of this cost expressed as an annual rate of interestThe cost of capital shows the price at which investors are willing to buy in to the risks(and returns) that the pany offers. The determination of a suitable required rate ofreturn for a project based on the cost of capital is discussed in detail in the first sectionof Chapter 18. We shall see that the discount rate chosen should reflect the systematicrisk of the projectThe Actuarial Education Company@IFE: 2009 ExaminationsPage 4CT2-17: Capital project appraisal (1)ExampleEntrepreneur A approaches the bank with a low-risk business proposal and is offeredfinance at 10% pa for the project. Entrepreneur B approaches the bank with a differentproject and is offered finance at 15% pa for the project. What does this tell us about thetwoprojects?apart from the obvious conclusion that b has not sold himself as well as a, and shouldconsider giving up his entrepreneurial career and apply for a job in the bank, there are anumber of conclusions we can draw. First we ask the question: is the bank looking for50% extra return from Project B pared to Project A?-probably notThe bank has to achieve a certain return for its shareholders and it will consider allprojects equally. The bank clearly perceives Project B as carrying higher risks, either ofplete failure or of not achieving the stated returns. Therefore the bank charges ahigher return to pensate for the risk of future defaults1.2 Initial appraisalBefore proceeding with a full-scale time-consuming and costly detailed projectappraisal, the pany's project analysts will usually undertake a quick initial appraisalThe main purpose of the initial appraisal of a proposed capital project is toascertain whether the project is likely to satisfy the criteria which have beenestablished by the sponsoring organisation for projects it is prepared toauthorise and hence whether it is worth carrying out a detailed appraisala key word here is likely. If the initial appraisal suggests that the project is likely toatisfy the relevant criteria, only then will a more detailed appraisal be undertaken toconfirm or reject these provisional results. The sponsoring organisation may have asingle set of predetermined criteria, or the criteria may be varied according to thepeg a"low-risk”printernal rate of return of 15% pa pared to 25% pa for a"high-risk" "projectQuestion 17.2Describe what you believe to be the meanings of"high-risk"and"low-risk "in the abovestatementC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Page 5These criteria will typically be expressed in terms of the financial resultsexpected and(sometimes) the risk that these results may not be achievedHowever, there may be many additional criteria in practice, includingachieving synergy or patibility with other projects undertaken by thesponsor, eg the development of a new product that can be sold in conjunctionith an existing productsatisfying"political constraints", both within and without the sponsoringorganisation. Is it acceptable or even desirable in the eyes of seniormanagement and/or even political representatives, either or both of whom mayneed to give approval before the project can proceed?having sufficient upside potentialusing scarce investment funds or management resources in the best way.Although the particular project may appear profitable, there may be other evenmore profitable projects or uses for the available fundsIn other words, the main criteria by which to judge the attractiveness of the project arethe usual ones of risk and expected return, together with an assessment of how far theproject is likely to satisfy any other objectives that the investor might wish to achieveFor example, how well does the project fit into the overall project portfolio? Are thereany spin-off effects for other projects- perhaps in the form of reduced average costs,once these are spread across the two projects?During the appraisal process it will be necessary to investigate the risksinvolved in the project and e to a view on the best course of risk mitigationhaving regard to the costs involved. the remaining risks will need to be listedfor the benefit of sponsors, lenders and investors, so that they can take theserisks into account in the decision-making processWe will discuss the analysis and mitigation of specific risks in detail in the second partof Chapter 18Since detailed analysis is an expensive process, it is necessary for the analysisto be iterative, getting into the more plex evaluations only once it is clearthat the effort is justifiedThe Actuarial Education Company@IFE: 2009 ExaminationsPage 6CT2-17: Capital project appraisal (1)With each subsequent and more detailed analysis of the viability of the project, thefinancial model of the project is made increasingly plex and sophisticated, so as togenerate more accurate projections of the likely financial outes of the project. Forexample, making more accurate-or indeed any -allowance for factors such astaxskthe sensitivity of cashflows to different economic scenariosIn this way, the level of uncertainty attaching to the appraisal is reduced1.3 Definition of projectThe first step is to define the project and its scope carefully and to assess itslikely length of operating life for the purpose of the appraisalPoints to note here are thatThe definition and scope of the project must be unambiguously set out andagreed by the various parties involved and should include careful reference toany interactions with existing projectsThe length of the project might itself be one of the criteria by which it is judgedThe scope of a project might includethe specific objectives of the projectthe principal activities in each stage of the project, eg construction of asset,useof assetthe aims, scope and timing of investment and the stages of the investment cyclethe key financial and other parameters(at each stage of the process)the way in which the oute of the project is to be measured, eg NPV, IrRthe success criteria of the project, eg a positive NPv based on 12%o pato whom(or which departments) the goals of the project apply(and who shouldnot be affected)the exact responsibilities of the various people in the project teamthe responsibilities of the management team to whom the project will reporttime limits beyond which the project team's responsibilities and powers will notextenda list of connected issues for which the project team is not responsibleC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Page 7It is hard to generalise, however the failure of many projects occurs because the scope ofthe project was not specified clearly enough. Consequently during the project, theindividual goals and responsibilities may bee unclear and confused and the projectwill fail to meet its targets1.4 Evaluation of cashflowsThere should then be an evaluation of the most likely cashflows for:capital expenditurerunning coststermination costsThis will often be based upon the best point estimates of each of the main cashflowsThese cashflows should be expressed in terms of present-day money values andshould exclude financing costs such as interest, depreciation, effects of priceinflation, etc. However, if any of the cashflows are expected to increase in reaterms(eg in line with wages rather than prices), this must be taken into accountThe cashflows should allow for any consequential effects on the sponsors otheractivities or costsThe initial appraisal is usually based upon real values for the cashflows-the cashflowsperhaps being easier to interpret if expressed in present-day money values-discountedusing appropriate risk-adjusted real discount rates. Again any interactions or synergieswith existing projects must be allowed for appropriately. For example, sharing of costsby-products or spin-offsAccurate definition and evaluation of the most likely cashflows is crucial to thesuccess of the subsequent work, as these constitute a baseline. Great caremust be taken, with all the assumptions made being carefully documentedQuestion 17.3A software pany is assessing whether or not to develop a "second generationfinancial modelling package for insurance panies. What synergies with otherproducts might it need to consider as part of its project appraisal?The Actuarial Education Company@IFE: 2009 ExaminationsPage 8CT2-17: Capital project appraisal (1)2 Methods of project evaluationUsing these cashflows, the next step is to make a very crude initial evaluation ofthe likely financial result of undertaking the project. a discounted cashflowapproach is normally usedThe two main discounted cashflow approaches arenet present valueinternal rate of return2. 1 Net present value(NPvThe NPv method models all the cashflows of a project until termination anddiscounts these back to the present day using the cost of capitalNPV is therefore an example of a discounted cash flow(DCF)approach to projectevaluationIf the result is positive then the project will improve shareholder returns since itearns a rate of return greater than the weighted average cost of capital (ie a return greaterthan the opportunity cost of the funds provided by the shareholders and debtholders)As we have said, initially a crude analysis is performed with the most likely values ofthe cashflows. However, the pany can allow for risk within the NPv methodRisk is best allowed for in the model explicitly so that the pany will look atthe weighted average NPv of a range of scenarios. The pany would need tobear in mind its risk tolerance in deciding how to finance the project. Thediscount rate used could be different for different types of project.For example, a high discount or hurdle rate might be used for projects that are deemedto have a high degree of systematic risk. In addition, we will see below that paniesmay deliberately use high hurdle rates in order to identify those projects that areparticularly profitable. If this is the case then it does not mean that a project is loss-making simply because it fails to meet the hurdle rate. It simply means that the projectis not as profitable as it needs to be to meet the panys criteriae will discuss the determination of the required rate of return for a project in detail inthe first section of Chapter 18C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Page 9Question 17.4WrongTurn Ltd is analysing two projects, the first of which(Project A) gives thefollowing estimated cashflows at the end of each of the ing years(a negative orbracketed number indicates cash spent by the pany, and a positive number indicatescash earned)Time in yearsCashflow(in S millions)(4)The second project(Project B) gives the following cashflowsTime in yearsCashflow(in S millionsIf the pany sets a hurdle rate of 20% pa for its projects, which of the above projectspass the test?Question 17.5On further analysis of Project A, Wrong Turn finds that the risk involved in thecashflows es primarily from one source of uncertainty, which it analyses furtherThe cashflow at the end of Year 2 has a high risk of not materialising. In fact there is a25% chance that the cashflow will simply not happen, and a 75% chance that it will infact be earneIf the pany wishes to analyse Project A using its cost of capital(15% pa)rather thaan arbitrarily high hurdle rate of 20% pa, how can this be achieved? (We will refer tothis project after allowance for the reduced expected cashflow at time 2 as Project C)Some panies take a more relaxed view for small expenditures and demand ahigher rate for large expenditures@IFE: 2009 ExaminationsCT2-17: Capital project appraisal (1)The calculation of the NPV for a project should be straightforward for a student who haspassed Subject CtI. What is new, and is examinable in Subject CT2 ishow to derive the data using the information given in the questionhow to calculate an appropriate rate of interest to use in the calculationhow to analyse and allow for the risks indicated in the questionhow to interpret the results of the analysisObviously, in order to test these skills, questions will require the student to calculateNPVs from time to time2.2 Internal rate of return(RR)DefinitionThis is essentially the same in method of calculation as the NPv, the differencebeing that rather than discounting at the cost of capital, a solution is found forthe interest rate that gives the project a zero NPv.this is higher than the cost of capital then the project may proceed le project. IfThe method has the benefit of highlighting the return achieved by the project. IfIf a project has an irR which does not satisfy the pany's criteria, this does not meanthat the project is loss-making. It simply means that it is not profitable enough to satisfthe minimum requirements (for example, a cost of capital requirement) set by thepany.The simplest method of finding the irr by hand is to plot the npvs at various discountrates on a graph and estimate where the graph crosses the x-axiC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)ProblemsHowever there are practical problems with the IRR approachNonsense results may be obtained if the initial capital is small giving veryhigh positive(or negative) solutions, two solutions or no solution at allQuestion 17.6Calculate NPVs at discount rates of 5% pa, 20% pa, 100% pa and 1,000% pa forProject C using the weighted mean of the two possible scenarios, ie use a final cashflowof +3. Do the same for Project BUsing the information given, estimate the irr of both projectsPlot the NPvs on a graph against the discount rate and ment on the implicationsWhereas the average net present value of a range of scenarios can befound simply by summing the value multiplied by the probability of thescenario, the same is not true for the internal rate of returnIt should be noted that the iRR equation can sometimes have multiplesolutions, especially if there are net negative cashflows at some pointsduring the operating life of the project or at termination. This has helpedto make it less popular than the nPv as a measure of project worthDespite these problems, the internal rate of return can provide a singleconvenient toolOne main advantage of the IRR is that it provides a rate of return for the project. Assuch it is intuitively easy to understand for non-expertsQuestion 17.7Show that by participating in both Project C and Project B, one achieves an NPV(at adiscount rate of 15% pa) equal to the simple sum of the two individual npvs forprojectsShow that the irr for the bined project is not simply the weighted sum of the twoIRRsThe Actuarial Education Company@IFE: 2009 ExaminationsPage 12CT2-17: Capital project appraisal (1)2. 3 Annual capital chargeThis method expresses the capital outlay as an annual charge, thus writing offthe capital steadily over a period of years. This charge may then be offsetagainst the benefits and if the net result is positive the project or capitalexpenditure proceeded withThis method is valuable in that it can show the impact on the pany's profitstream of an investment. The short-term impact on earnings may be highlysensitive, as it is very visibleThe annual capital charge is similar in concept to the depreciation charged through thebalance sheet. The initial capital expenditure is amortised over a specified period andoffset against the profits from the project as they accrue. There are then a number ofways of using the resulting net earnings figures. They can be simply accumulated toestablish the year in which the project moves in to profit, or they can be added to thepany's other forecast earnings to see the overall impact on the reported figuresClearly this is most useful when the other earnings in the reported profits aredepreciated on a consistent basisThis method works well looking at capital expenditure on machinery or plantand benefits from being simple and easily understood. It should not be ruledout just because there are more plex methods availableQuestion 17. 8Project D involves an initial investment of 10. It is estimated that the project willgenerate subsequent cashflows of +3, +372, +4 and +4 at times t=1, 2, 3, 4. Calculatethe net cashflows after allowing for an annual capital charge using a 4-year amortisationperl2.4 Shareholder value approachShareholder value represents the present value of all expected current andfuture cashflows available to shareholdersThe shareholder value method is based on but extends the NPv approach. Themethod has the important distinction that it is looking at the pany from thepoint of the external shareholder and less on the internal issues governing theattractiveness of a project. It is, therefore, a holistic method rather than anincremental method focusing only on the project itself.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)The way the method works conceptually is very simple. the total value of thepany is examined on a"before and after"basis. the way the pany isvalued currently by the market needs to be understoodThis is where the human element es in It is notoriously difficult to say whatinvestors"in general are looking for in a pany 's sharesDepending on the sector, price earnings ratios or price to net asset ratios maygive an indication of how a pany stands in relation to its petitorsComparison of key figures such as these with petitors will help determine apany's standing in the market. The difference in rating is the value beingplaced by the market on the management's ability to grow the businessprofitably. If they have high confidence then the capitalisation of the panywill be high in relation to its peersRecall that investment ratios were discussed in detail in Chapters 12 and 13. amongstthe most important ratios with regard to shareholder value are the price earnings ratioand the gross dividend yieldQuestion 17.9Define the price earnings ratio and the gross dividend yieldQuestion 17.10Company A and Company B are quoted in the same industrial sector. The followingobservations can be made of the two paniesCompany ACompanyCurrent market price200300Historical gross dividend20pHistorical earnings per shareA financial analyst in Company a is considering using the shareholder value" methodto assess a project. She is wondering what the above information indicates about howthe market perceives the pany relative to its petitors(i) Draw your own conclusions based on the data above(ii) Give reasons why the above analysis might be tenuousThe Actuarial Education Company@IFE: 2009 ExaminationsPage 14CT2-17: Capital project appraisal (1)The value added approach then adds in the new project or pany purchaseand looks at all the valuation issues above to see what the impact is. thempact on net asset value, future earnings and debt cover may all be calculatedrelatively easily and one would add in to the pany model the cashflowscenarios developed for the NPv method. the important element of the valueadded process now es into action for it has to look at the impact of the newproject on the rating of the panyIssues to be evaluated would includempact on ranking versus petitorspossible petitor reactions and change in level of petitionimpact on perception of managementimpact on analyst perceptionsmpact on debt ratingenhancement or dilution of earningsmpact on dividend policympact on stock betaThe addition of a new project to the business could have an impact on the wholeway the business is perceived and so fundamentally alter the share rating. Thevalue added approach tries to look dispassionately at the before and afterpositions and the result measured is the increase in value of the shares to thecurrent investorsThis is clearly a subjective decision, as many business decisions are. However, themethod has the advantage of allowing numerate managers to mix the rigorous financialcalculations and cashflow projections with the uncertainties of the market, andwith a decision that fits with the strategic direction of the pany and adds shareholdervaucThe shareholder value added approach has exciting possibilities for actuaries asit is inherently very plex and will benefit from careful mathematicalmodelling of all the interactions and feedback loops to ensure all theramifications of the project have been thought of. It gives clear-sightedmanagement the opportunity to adopt exciting new policies that are wellreceived by the stock market which might have been overlooked if one merelyevaluated projects on a narrow basis looking only at the project itself.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)The disadvantage of such a method is that it involves rating the project on a number ofdifferent criteria, some of which may be perceived as more important and some lessWhen debating the pros and cons of a number of projects, there may be no clear winneor loser. It may be a matter for discussion which factors should be rated most highly inthe analysisIn addition, the stockmarket itself is prone to changing its focus regularly. Companiesthat are valued on the basis of net asset value one year, suddenly bee valued on theirprospects for growth the next. This can add plexity, but does not undermine themethodology2.5 PaybackIn many small panies it is cashflow that is crucial and so the speed at whicha project can recoup its initial investment is vital. For a small fast growingpany that will find it hard to raise debt and whose shareholders are alreadystretched, payback bees the crucial factorPayback periodThe project with the faster payback period will be preferred. Alternatively, themethod can be used to identify the project that generates the most funds over aspecific time period, say 3 yearsQQuestion 17.11Under what circumstances might a pany be more interested in looking for theproject that generates the most funds over a 3-year period, rather than the project thathas the shortest payback periodThe method is of relatively little value where payback terms are much over threeyears.This is because it does not allow for discountingNevertheless, in view of its simplicity it continues to be a popular method and isused by over one-third of panies according to the "Target Practice"surveyconducted by the aca and the cbl in 1998The Actuarial Education Company@IFE: 2009 ExaminationsCT2-17: Capital project appraisal (1)The ACA is the Association of Consulting Actuaries. The CBI is the Confederation ofBritish industrWe demonstrate the above concept using the following exampleExampleTime in yearsCashflow(S millions4322Cumulative cashflows (4)(7)(5)(1)4The table above describes the expected cash inflows and outflows in respect of aprojectThe payback period would be found by looking at the cumulative cashflows, andestimating the time at which it changes from negative to positiveThis looks to happen around one third of the way through Year 4. So the paybackperiod is about 3.33 years, assuming continuous cashflowsQuestion 17.12Under what circumstances might the payback method be applicable?2.6 Nomina returnsThis is a variant of the payback method where one simply pares the ratio ofcash generated to cash consumed over a period. It can give a quick idea of therelative profitability of projects and is an adequate approach where the ratio canquickly be seen to be high. Again, the term over which such an evaluation ismade should be shortExampleFor the project in the example above, the nominal return over a 4-year period is9/7≈13The method is normally used(and is better suited) to projects that involve a single cashoutflow in the first year and an inflow in subsequent yearsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Page 172.7 StrategicfitStrategic fit will normally form a part of every project evaluation as every projectshould fit logically with the business, building on its areas of expertise,resources or customer base. Sometimes a new departure into a business sectorcannot be justified on purely financial grounds but it is being taken because of aview being taken on the way the industry is moving.Often projects cannot be analysed on financial grounds, and can only be subject toqualitative analysiExamplea retailing pany is considering offering free internet connection to its customers,the costs are real and tangible, but the benefits are largely qualitative for the foreseeablefuture. The decision could be analysed as follows:Installing networkMaintenance costs$0. 2m pa(inflation linked)ReAdvertising/banners$0.05m pa(inflation +6%(or maybe +60%)growth)ualitative benefitsFuturets of internet very highBrand recognitionmediuCustomer appreciationselective, but very highlong-term future of iopping briglThe qualitative benefits of the move might outweigh the obvious costs in the short termIt could certainly take a long time for the npv to becurrent management of the pany would be willing to look at. However the strategicdecision could be made to acquire a presence in the internet industry, and this could bedeemed a worthwhile investment@IFE: 2009 ExaminationsCT2-17: Capital project appraisal (1)There are parallels with the methods outlined above when one takes intoaccount a range of scenarios. The difference here is that one is picking aparticular future business scenario and developing a business response on theassumption that this future projection holds good. Such an investment can reaphuge rewards if the future goes as predicted and there are opportunities to begained by being ahead of the pack. If things do not turn out as expected theproject has to be carefully monitored to limit the potential downsideIn the example above, the case for continuing to offer free internet connection wouldhave to be regularly and thoroughly reviewed. Factors we might need to considerincludeAre the costs on track and still justifiable?Is the business justification for the direction still valid?Can we monitor the results of the"qualitative"benefits and convert them intoanything close to hard cash?Having monitored the experience, should we be building up or reducing ourinvestment?What is the response of our petitors to our project?the insurance industry in the UK we have seen over the last ten years massivechanges in distribution methods and many of the investments made could onlybe justified on strategic groundsOf course most projects can be analysed using projected cashflows, and one can take theview that the investment must justify itself. Even the changes to insurance productdistribution networks can be justified if one looks sufficiently long term, and is willinto make the heroic assumptions that are requiredHowever, when the parameters bee more"guesswork"than science, and thevariability of the inputs bees too high, it is often better to accept that it is a purelysubjective decision, and make the decision on that basis. Even in these circumstancesthere is always a place for good technical analysis, and there are always areas in whichthe concepts and methods discussed in this chapter can add valueSo if a business does the right thing"then the required return es as a by-product and is not the deciding factor There is scope for actuaries to developmore sophisticated models that build in explicitly these " difficult to quantifybenefits. Indeed, any project may bring with it intangible benefits that it may bepossible to value if sufficient thought is given to the exerciseC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)2.8 Opportunity costIt is all too easy to put up a project that may satisfy the business criteria foracceptance but not be the best way of proceeding. There may be somealternative opportunity that is even better that has not been consideredThe opportunity cost method asks "What alternative ways could we spend thismoney and what return would be achieved?Thus, even if a project does satisfy the criteria applied by the pany it might not bethe best opportunity available to the pany. Recall that one of the sponsor's criteriain Section 1. 2 required that the project be the best use of scarce management time andresources. It is therefore always worth looking at all the available projects beforemaking a decision, and choosing the one that best satisfies the financial and qualitativecriteriathan alternatives with a similar risk profile even if under the true cost of capita 7Apart from this method proving useful to help identify better alternatives, it caalso on occasion justify spending when there is surplus capital that cannot forsome reason be invested to earn the cost of capital return It may be in thepany's interest to invest in this project as long as it yields a better returIt is often the case that a pany will identify a project it believes would strengthen itsposition in the industry. However it cannot justify the expenditure using a cost ofcapital analysis. If the pany has capital available to invest, it has two optionsreject the project and continue searching for projects that do satisfy the internalrate of return requirement2. test the rejected project using a lower cost of capitalThe pany must consider the return it will get if it rejects the project but can find noother project to invest in and therefore invests the surplus cash in the money markets. Ifthe irr of the project is higher than money market returns, then it might be better toundertake the project than to simply leave the funds invested in money market depositsIf the management decide that there is a risk that an alternative will not be foundquickly, and that the money will lie idle for some time, it may be that the opportunitycost of not undertaking the initial project is large. They should begin the project as analternative to investing in the money marketIt should be remembered that returning capital to shareholders is an option, butthere are frictional costs if the pany finds itself wanting to raise new capitalat some future pointThe Actuarial Education Company@IFE: 2009 ExaminationsPage 20CT2-17: Capital project appraisal (1)Question 17.13How might a pany return funds to shareholders?This is not really a new method as all the items could be incorporated in themain methods: it is the focus of attention on alternatives that is the difference2.9 Hurdle ratesAgain this is not a new method but can be used or incorporated in the methodsabove. The emphasis is that the pany sets a target rate of return, or thehurdle rate. This could typically be quite high and well in excess of the true costof capital. For example, a pany might set a target return on capital of 20% inorder to concentrate minds on only the most profitable projects. Only projectswith a positive NPv discounted at 20% or an iRR in excess of 20% would getpast the first screeningn reality, the project champion is likely to emphasise the potential upside todemonstrate the high return, understating the risk. The actual achieved returnon accepted projects is therefore liable to e in well below the business planhe approach has the advantage of exposing the really high potential projectswhich, if managed well, will bring in high returns. The flip side is that manyexcellent more low-risk projects that would deliver good returns above the costof capital(but below the hurdle rate)will never be considered.Clearly if a pany intends to look only at projects that deliver returns in excess of20% it will get a bination ofextremely high-risk projects, which may if successful give a superior returnprojects presented by over-ambitious project managers who dearly want theirproject to get the go-ahead. They therefore underestimate the risks and overstatethe returns in the project submissionhe rates actually being used by panies of different sizes have beensurveyed. this showed an average irR hurdle rate of 17. 1%, which is very highpared with the long-term achieved returns on equityQuestion 17.14Why might the use of high hurdle rates be mon in industryC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Page 212.10 Receipts/costs ratioAnother measure, which is not often employed but which can sometimes beuseful is the receipts/costs ratio, defined asNPv of the gross revenuesNPV of the capital and running costsThis indicates the level of profit as a proportion of costs and is therefore related, butdifferent, to the concept of the profit margin encountered in the financial analysis ofpanies. It can therefore be used to rank peting projects where there is aconstraint on the total amount of funds available for investmentQuestion 17.15What are the major difficulties with using the irR and the payback period as projectappraisal techniques?The Actuarial Education Company@IFE: 2009 ExaminationsCT2-17: Capital project appraisal (1)3 Results of the evaluation3.1 Initia/ resultNormally the result of an NPv calculation would be regarded as satisfactory if itwas positive and the result of an IRR calculation would be regarded assatisfactory if it exceeded a predetermined"hurdle rate"set by the sponsor. Thepayback period would be regarded as satisfactory if it was less than apredetermined period set by the sponsor.The choice of the discount rate used with the npv or the hurdle rate with which the irris pared is therefore crucial- likewise the choice of payback periodQuestion 17.16Why is the choice of the discount rate used with the NPv so important?The results of these calculations will provide a crude initial appraisal of thefinancial viability of the projectHowever there are a number of simulation techniques that can be used to obtain a fullerunderstanding of the viability of the project3.2 SimulationSensitivity analysisHaving modelled the project for the purposes of evaluation, we may wish toapply sensitivity analysis to see how the value of the project changes withdiffering future conditions. We take each key assumption in turn and assess theeffect on NPv of the most optimistic and pessimistic results occurringa broad idea of the sensitivity of the results to varying assumptions can beobtained by assuming that all the costs are (say)10% higher than the most likelyvalues and all the revenues are(say 10% worse than the most likely valuesHowever, it is important to understand the impact of each individual assumption, so forsensitivity analysis we take each key assumption in turnC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)In this way, we can identify which are the variables that have the greatest effecton the oute of the project, thereby determining where more information isneeded(and when forecasts are inappropriate, confused or inconsistent)To demonstrate this, consider the following example.ExampleI Inflation Consumer spending Borrowing costshighAssumptionless 2% Plus 2% less 2% plus 2% less 2% Plus 2%Net effect on NPvS millions1.53.26.24.52.58.9Having pleted the central NPv estimate for a particular project we now wish to testthe sensitivity to the key assumptions- these being inflation, consumer spending andborrowing costsThe results shown in the table above demonstrate that the project would benefit fromhigher inflation and higher consumer spending, but that the key exposure on thedownside is an increased cost of borrowing. The results demonstrate how theprofitability is affected by movements in the underlying parametersHowever, the results give no indication of the interaction between the variables. Forexample an increased cost of borrowing may well occur at times of high inflation, butthe reader is given no idea of this interactionScenario testingHowever, sensitivity analysis does not allow us to consider theinterrelationships between input variables.To do this, we need to employ scenario testing, where we consider someplausible binations of input values and see what effect these have on theprojectcenario testing(often called stress testing in the financial world)involves choosingparticular scenarios or binations of factors to which the project or institution may beexposed. The effect of the bination of events is then modelled and investigatedshowing the overall resulting financial gain or loss for the panyThe Actuarial Education Company@IFE: 2009 ExaminationsPage 24CT2-17: Capital project appraisal (1)ExampleFor the above project the results of a scenario test might look like thisscenarioGain/LossInflation+2%. cons spending+ 1%, borrowing+ 3%S1.5mInflation%, cons spending 3%, borrowing-2%It can be seen that these scenarios can be chosen to show particular binations ofevents- perhaps those to which the profitability of the project is highly exposedAlternatively the scenarios can be chosen to show particular circumstances that thepany management believes to be highly likely to occur. Or perhaps the pany isalready expthat it hasundertaken. and wants to be clear on the implications of yet further exposure to the sameriskQuestion 17.17Describe why it might be important to perform both a sensitivity test and a scenario teston the results of a projectBut even scenario testing will involve a limited number of plausiblebinations, which may or may not include the most optimistic andpessimistic values. To consider all possible binations we need to useMonte Carlo)simulation.Monte Carlo simulationHere we look at the entire distribution of possible project outes. In order todo this we need tomodel the project (usually on a puter), allowing for interdependenciesand serial correlationsspecify probabilities for the distribution of the key variables(possiblyinvestigated by the use of sensitivity testing)simulate the cashflows many times using values extracted randomly fromthe distributions of possible variable inputsrecord and order the outputs to assess their probability distributions.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)But note that this process is critically dependent onan appropriate model designappropriate assessment of the probability distribution of the inputs.The former is a particular problem when the model builder is not experienced inthe field being modelledMonte Carlo simulation involves creating a model, into which all the variabilities andcorrelations of the input criteria are entered. The model then runs a large number ofsimulations to obtain a spread of resultsThe resulting chart may look like thisE5932=9SProject NPV in t millionsFigure 1: Results of monte carlo simulationsFrom the chart we can identify the mean profit, the spread around that mean, and theshape of the profitability chart, which here appears to be negatively skewed(due to thelong lower tail)Financial modelling software can be purchased that has been specifically designed forcarrying out Monte Carlo simulation. Indeed, the process is so plicated that manymodels, each specific to a particular sector of a particular industry, have been designedThe Actuarial Education Company@IFE: 2009 ExaminationsPage 26CT2-17: Capital project appraisal (1)Question 17.18What are the main advantages and disadvantages of performing a Monte Carlosimulation as part of a project appraisal?Scenario testing and Monte Carlo simulation are plex and therefore expensiveThey are unlikely to be performed at an early stage in the project appraisal processHowever, sensitivity analysis is simple, and therefore cheap, and could quite easily beused alongside the initial evaluation of cashflows(See also Chapter 18 Section 5 for further discussion of scenario testing andstochastic modelling.3.3 Results of the analysisThe results obtained might, if very unsatisfactory, suggest that further analysisis not worthwhile without some fundamental redesign of the project. Ifhowever, the results appear satisfactory, it is not sufficient to stop there, and aproper risk analysis should take place as indicated in Chapter 183. 4 A note about taxIn the initial stages of the analysis it will usually be sensible to exclude thenegative cashflows resulting from corporationsince these will depend(among other things) on the method of finance adopted and it is an unnecessaryplication to rework the tax every time the nPv is reworked during theanalysAt the final stage, when the investment submission is being prepared, thenegative cashflows arising in respect of corporation tax can be evaluated(allowing for appropriate timelags in the collection of the tax) and discounted inorder to arrive at a suitable deduction from the npvIn practice we will be interested in the NPv of a project net of any tax payments, orequally the net-of-tax IRRThe above is an example of the process whereby successive iterations of the appraisalprocess can introduce more plex and hence realistic modelling of the projectC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Question 17.19What is the main difficulty associated with the use of the NPV method of projectappraisal?In the past examination questions seem to have concentrated on the relative merits ofdifferent methods of investment appraisal. For exampleExplain why the net present value criterion is superior to other methods of investmentappraisal. (September 2001)If you consider the strengths and weaknesses of other methods and contrast them withthe NPv, you should be able to make some good points. For example, the NPvconsiders all cashflows(whereas the payback method does not); the NPv considers thesize of the project (whereas the payback and the internal rate of return do not)etc.The Actuarial Education Company@IFE: 2009 ExaminationsCT2-17: Capital project appraisal (1)This page has been left blank so that you can keep the chaptersummaries together for revision purposes.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Chapter 17 SummaryCapital project appraisalA capital project involves an initial expenditure and then, once the project es intooperation, a stream of revenues less running costsAn initial appraisal assesses whether the project is likely to satisfy the sponsor'sriteria. such asachieving synergy or patibility with other projects undertaken by the sponsorsatisfying "political constraints", both within and without the sponsoringorganisationhaving sufficient upside potentialusing scarce investment funds or management resources in the best wayThe first step of the appraisal is to define the project and its scope carefully and toassess its likely length of operating life for the purpose of the appraisalThere should then be an evaluation of the most likely cashflows, expressed in terms ofpresent-day money values, for capital expenditure, running costs, revenues andtermination costsMethods of project evaluationThe net present value (NPn) method models all the cashflows of a project untiltermination and discounts these back to the present day using the cost of capital. Apositive result indicates that the project will improve shareholder returnsThe internal rate of return(IRR) is the interest rate that gives the project a zero NpvThis is pared with the cost of capitalThe annual capital charge expresses the capital outlay as an annual charge, thus writingoff the capital steadily over time. This charge may then be offset against the benefitsThe shareholder value approach attempts to assesses the impact of the project on thevalue of the pany as a whole from the point of view of shareholdersThe payback period measures the time it takes for the accumulated cashflow from theproject to bee neutralThe Actuarial Education Company@IFE: 2009 ExaminationsCT2-17: Capital project appraisal (1)Nominal returns pares the ratio of cash generated to cash consumed over a periodStrategic fit assesses how the project fits in with the rest of the pany's businessbuilding on its areas of expertise, resources or customer baseThe opportunity cost method asks"What alternative ways could we spend this moneyand what return would be achieved?Companies sometimes assess the profitability of a project against a hurdle rate of returnThe receipts/costs ratio is defined asNPy of the gross revenuesNPV of the capital and running costResults of the evaluationNormally the result of a NPV calculation would be regarded as satisfactory if it waspositive and the result of an IRR calculation would be regarded as satisfactory if itexceeded a predetermined"hurdle rate"set by the sponsor.These results offer a crude initial appraisal of a project. To gain a fuller understandingof the viability of a project, simulation techniques can be usedSensitivity analysis takes each key assumption in turn and assesses the effect on theNPV of the most optimistic and pessimistic results occurringScenario testing involves changing plausible binations of input values and seeingwhat effect these have on the projectMonte Carlo simulation attempts to look at the entire distribution of possible projectoutes via numerical simulation. It is critically dependent on an appropriate modeldesign and appropriate assessment of the probability distribution of the inputsIf the results from an initial cashflow analysis are very unsatisfactory, then furtheranalysis is unlikely to be worthwhile without some fundamental redesign of the project.If, however, the results appear satisfactory, then a proper risk analysis should take placeThe analysis is usually refined to allow for plications such as corporation tax only atits later stagesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Page 31Chapter 17 SolutionsSolution 17.1Examples of capital projects include theconstruction of fixed capital assets, eg new factories or aeroplanessetting up of a new businessmodernisation of an existing asset, eg a puter system, or a businessredevelopment of an existing asset, eg a propertymerging of two paniesSolution 17.2Most projects can be analysed in terms of cash inflows and cash outflows. A high-riskproject might be one in which the cashflows cannot be predicted with any degree ofcertainty. Another way of describing the above would be to say that the graph of npv(on the x-axis) against the probability of each oute (y-axis) would show a widespread of outes for the project. A low-risk project might show a narrow spread ofresults with a high certainty of a profitable outeSolution 17.3a potentially beneficial spin-off is that panies who buy this new financial modellingpackage might also buy other modelling packages from the software pany in thefuture. On the other hand, sales of this new financial modelling package might simplyreplace sales of the software panys existing"first generation"financial modellingpBoth of these possibilities would need to be allowed for in theappraisalThe Actuarial Education Company@IFE: 2009 ExaminationsPage 32CT2-17: Capital project appraisal (1)Solution 17. 4Both!At 20% the npv of project A isNPA=-4+~20.44(1+0.2)(1+0.2and of Project B isNPVB=-2+_150.78(1+0.2)Solution 17.5By allowing more precisely for the final cashflow, it can be determined that theexpected value of the payment would be 0.25X0+0.75X4=3. Reworking the equationwith a final payment of 3 and a discount rate of 15%o pa gives2NPVc0.008(1+0.15)(1+0.15)2ie the project satisfies the requirement gustAlternatively one can analyse the project as a weighted average of two scenarios,NPy4+a+015+a+0.76with a 75% chance of occurring, andNPV4+(1+015a 25% chance of occurringThe value of the average0.25×(-226)+0.75×0.76=0.008C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Solution 17.6The following graphs show plots of the NPVs for a variety of discount rates. The firstover a restricted range of rates(5% to 20%)and the second graph over a less restrictedrange(up to rates of 1000% pa)0.6ct cct B三0.2010%15%20%2NPv project CThe Actuarial Education Company@IFE: 2009 ExaminationsCT2-17: Capital project appraisal (1)The results show that Project C is a typical project that has a positive NPV at low ratesof interest. The NPv for the project falls as the discount rate rises and eventually fallsbelow zero around the irr of 15%Project B however is loss-making at low rates of interest, and only when the discountrate is sufficiently high(greater than 9%)does it bee profitableIt can be seen that Project B has a further solution for the IRR equation( NPVB=0).This occurs at a discount rate of around 540%Trying to summarise this in words is not easy, howeverUsing very low rates of discount, the project is loss-making, largely because thsum of the two payments in year I and 2 amounts to +l million, which is notsufficient to offset the initial payment at time 0 of-2At modest rates of discount the project is profitable because the rate of discountand the one-year time gap between the two large payments bine to give us avalue- sufficient to overpower the initial paymentAt very high rates of discount, the final two payments bee negligible in size,leaving only the initial payment to influence the present value calculationTherefore the project has a negative value againSolution 17.7The bination of the two projects gives cashflows of2Cashflow(in millions)17This is profitable at most discount rates up to 83% at which point it bees lossmaking. Clearly 83% is no bination of 15% and 9%. It is more plausible that itcould be a bination of 15% and 540%. however this is not the case. The result ismore easily demonstrated using two projects, each of which has only one IRR solutionSolution 17.8Writing off theitial investment over a 4-year period, implies an annual capitalharge of 212. So the net cashflows after the annual capital charge are +12, +1, +lv and+12 at times t=1. 2. 3. 4C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Solution 17.9Price earnings ratiomarket price of an ordinary shareearnings per shareGross dividend yieldgross dividend per sharemarket price of an ordinary shareRecall thatearnings is the profit earned by the pany after tax and is therefore the amountavailable for distribution to the ordinary shareholdersthe dividend is the amount actually distributed to shareholdersThe price earnings ratio therefore shows the multiple of earnings that shareholders areprepared to pay for a particular share. The gross dividend yield shows the amount ofdividend received per unit of investment(the share price). It is usually expressed as apercentageSolution 17.10(i) Tentative conclusionsCompany aGross dividend yieldPE Ratioprice pershare108.6earnling per shareWe can say in general that Company a is rated more highly than Company B. Investorsare willing to pay a higher multiple of its historical earnings to buy the share. Thesubstantially higher dividend yield for Company B is simply a factor of the higherpayout ratio of Company B, ie Company B pays a higher proportion of its earnings individends. The immediate conclusion is that Company a is regarded more highly thanCompany B in the eyes of investors, perhaps because investors see greater potential inCompany aThis puts Company a under greater pressure to demonstrate this potential in profitableprojects. If a project earned the same return in Company a as it did in Company b thiswould cause the market to think that they had overestimated the potential ofCompany A. It will in general be harder for Company A to find projects that arebeneficial at the current share priceThe Actuarial Education Company@IFE: 2009 ExaminationsCT2-17: Capital project appraisal (1)In the time of the high-tech boom in the UK, many panies had extremely high PEratios, reflecting the confidence shareholders had in these panies. There was a greatdeal of pressure on these panies to find projects to justify the high share price() Reasons why the analysis might be tenuousAgainst this it should be mentioned that1. although the panies are in the same sector, they may not be directlyparable2. the historical carnings and dividends may be affected by one-off factors3. the panies may be valued by investors on various other grounds that are notmentioned in the question, eg market share, brand recognition, etcSolution 17.11(i) The pany has limited resources over the ing 3 years and so might be lessinterested in the total payback period, and more interested in the amount of fundsearned over the critical 3-year period(ii) The pany has a finite period over which to prove itself and so might be moreinterested in the amount of funds generated, rather than the speed of payback.(iii) The pany has a large amount of short-term outstanding debt that needs to beservicedNote that focusing on the amount of funds generated may involve overlooking betterprojects. It may be that a pany turns down a small project with a 2-year paybackperiod in favour of a larger one that happens to generate more funds over 4 years. Thimay well generate more funds over the specified 4-year period, but the pany willhave a lower return on capital because it did not select the smaller projectC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)Page 37Solution 17.12Payback period would be applicable whenthe size of the project does not warrant deeper analysis such as discountedcashflow techniquesthe hurdle rate(explained later in the chapter) is low enough such thatdiscounting makes littlethe project occurs over a short period of time where discounting is not warrantedand would make little impactthe cashflows themselves are so uncertain that the additional rigour ofdiscounting makes no sense or introduces spurious accuracy.Solution 17.13It might use share or stock buybacks, or alternatively simply pay a much larger dividendIt is also possible for panies to pay an exceptional dividend to shareholdershowever the tax-inefficiency of this route means that it is seldom followedSolution 17.14There are many reasons(i) They are simple to pute and understand(ii) Often the uncertainties in a project can best be modelled by a simple (say)% papound probability(cashflows at the end of the first year have a 0.95 chancef occurring, in year two they have a 0.95- chance of happening, etc). In suchcircumstances the hurdle rate can be viewed as a 15% cost of capital rate and a5% uncertainty rate, rather than a 20% hurdle rate(iii) Companies often have more than sufficient projects to be getting on with. If afurther project is to be accepted, and use up valuable scarce resources, it has tobe a really profitable one. Hence the high hurdle rateThe Actuarial Education Company@IFE: 2009 ExaminationsCT2-17: Capital project appraisal (1)Solution 17.15The main problems with the IRR are thatthe equation from which it is found may have no solution or multiple solutionit ignores the"scale "of the project. Thus, a small project with a high IRR butlower "value", may be accepted ahead of an alternative larger project with alower IRR, but a"higher"valueit ignores the timing of the receipt of future positive net cashflowsThe payback period ignoresthe time value of money -although this can be overe by use of thediscounted payback periodcashflows beyond the cut off dateSolution 17.16If the negative cashflows associated with a project mostly precede the positivecashflows, then the use of too high a discount rate will lead to the rejection of someprojects that are actually likely to be profitable (when assessed against an appropriatediscount rate). In addition, if the high return projects tend to be riskier, then this willlead to the acceptance of a preponderance of risky projects. It may also lead to a biastowards short-term projects, as long-term cashflows will be"over-discountedConversely, use of too low a rate will lead to the acceptance of some potentiallyunprofitable projectsSolution 17.17a sensitivity test shows the effect that an individual parameter has on the final resultBy holding all other parameters of a model constant and varying the input parameter inquestion it is possible to gauge the effect on the overall profitability of the projectHowever in many cases, a variation in one parameter should lead to a variation inanother. For example, if interest rates and inflation and earnings growth are parametersof a model, then it is unlikely that inflation is going to vary without affecting the othertwo parameters. It is more useful to test the scenario under which all three move in aconsistent mannerC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-17: Capital project appraisal (1)It is also the case that parameters may have offsetting or hedging effects on one anotherFor example, a seemingly risky exposure to high inflation may actually be reduced by acorrelated exposure to interest rate movement. What the project would lose as a resultof higher inflation, it would gain by higher interest earnings on cash balances. Thesecan also be modelled using scenario testingSolution 17.18Advantages includeincreased understanding of the project parametersgreater information on the results including not just the average expected profit,but also the spread of possible outes around the mean and the shape of thedistribution of such outes(fat-tailed, skewed, etc)identification of outliers- ie binations of events that can be particularlyharmful to the NPv of the project ( these can show up as bumps on theprobability distribution)Disadvantagincreased workload, which might not be justifiableerrors caused because of the plexity, leading to a wrong resultSolution 17 19The main difficulty associated with the use of the NPV is selecting the appropriate riskdiscount rate at which to calculate the npv. the choice of the discount rate is discussedin the first part of Chapter 18The Actuarial Education Company@IFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Page 1Chapter 18Capital project appraisal(2)Syllabus objective(vii) Define what is meant by a pany's cost of capital and discuss how its cost ofcapital interacts with the nature of the investment projects it undertakes3Describe methods monly used to evaluate risky investments includingprobability trees, simulation and certainty equivalents4. Discuss the issues in establishing the required rate of return for a capitalproJect.(x) Show how financial techniques can be used in the assessment of capitalInvestment projectsDiscuss the factors underlying the choice of discount rate within projectassessment includinthe assumptions and limitations in the use of the weighted average cost ofcapitalthe allowance for leverageallowance for risk3. Discuss the methods that may be used for identifying the risks that may bepresent for different types of projectDiscuss suitable techniques for ascertaining the probability of occurrence ofdifferent risks over varying timescales and the financial impact ofoccurrence5. Discuss suitable techniques for ascertaining the distribution of the possiblefinancial outes of a capital projectThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 2CT2-18: Capital project appraisal (2)0 ntroductionThis chapter continues and concludes the discussion concerning capital projectappraisalFirstly, in order to assess the likely profitability of a project using the discountedashflow techniques discussed in the previous chapter, we need to determine anappropriate risk discount rate or hurdle rate. This is considered in the Section 1 of thischapter, where it is suggested that our choice should reflect both the opportunity cost ofcapital and the degree of systematic risk inherent in the project. This section draws onideas covered in Chapter 15In Section 2, we consider a general approach for dealing with the risks that will bepresent in any project, a risk being any factor that may lead the actual timing and/oramounts of the cashflows generated by the project to differ from our estimates. Theapproach described is based on the risk Assessment And Management Of Projects(RAMP)methodology developed jointly with the Institute of Civil EngineersIn Sections 3, 4, 5, 6, 7 and 8 we look in detail at the identification of risk, the analysiof risk, the distribution of net present values, otherof appraising risky projects,risk mitigation and finally, the investment submissionYou will meet, and use, this material again in Subject cAl, in particular.project appraisal, and your knowledge and understanding of risk analyse a be tested onThis chapter could be the focus of a 20-mark question. You are likely toyourability to calculate and discuss the appropriateness of a particularC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Page 31 Choice of discount rate1.1 The basic theoryBackgroundThe use of the cost of capital to calculate the net present value in screeningprojects ensures that projects are only entered into that will enhance the returnto shareholders, provided that it is adjusted to reflect the project riskRecall from Chapter I that the cost of capital is usually defined as the rate of return thatinvestors forego by investing in the particular project in question, which in practice isequal to the rate of return available on other similar projects. Here"similar"refers tothe level of systematic risk involvedThe historical costs of the pany's existing capital is irrelevant. What isimportant is the current cost of raising incremental capital for the pany inorder to carry out the project.In other words, the cost of raising additional finance to fund the project via a rights issueor a new issue of debt, based upon current required rates of return in the marketplaceOne way of looking at this cost is that it is the rate of return which needs to bearned on the capital if the existing shareholders are to be no better off and noworse off. As a consequence of which the value of the pany's existing shareswould remain unchangedIt may be thought (wrongly) that one should look at the sources from which theincremental capital for the project will actually e. Hence if all the capitalwere to be raised from internal reserves or by a rights issue, the cost of capitalwould be equal to the total rate of return which could be expected to be earnedby the shareholders on their existing shares. If, however, the whole of thecapital were to be raised from fixed-interest borrowing, it would be the net costof that borrowing after allowing for tax reliefs and likely future inflation, whichwould need to be taken as the cost of capital. If part of the capital were raisedthrough equity and part through borrowing, we would need to look at theweighted average cost.Question 18. 1Explain what is meant by the expression "it would be the net cost of that borrowing afterallowing for tax relief, which would need to be taken as the cost of capital"in the aboveThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 4CT2-18: Capital project appraisal (2)However, it can be convincingly argued that it is irrelevant where the actualfinance for the particular project under consideration is ing from, and thatwhat matters is the pany s normal cost of raising new capital taking this asa weighted average where the weights are based on the optimum capitalstructure for the pany as between equity and debt f the pany'scapital structure is not currently optimal, it could be made optimal through aseparate decision .Weighted average cost of capitalAs we learned in Chapter 15, a pany's weighted average cost of capital (WACC)can be defined asWACC=Market value of debt x net cost of debtMarket valueof debt +equityMarket value of equityx cost of equityMarket value of debt +equityThe WACC is a weighted average of the cost of debt and equity capital of the panyOr equivalently, it can be regarded as the rate of return that must be achieved if theexisting shareholders are to be no better or no worse off. As such it therefore representsthe rate of return that should be used to discount the future cashflows generated by thepany from the various projects that it undertakesHence, if the pany is able to generate a rate of return in excess of its WACC from aparticular project, then that projecthas a positive net present value calculated at the wacc and offers a return tothe shareholders in excess of the Wacowill increase the value of thewhere this is calculated as the net presentvalue of all of its future cashflows and therefore make the shareholders betteroffAll else beit should therefore be undertakenAn additional plication, is that for any particular pany the WACC maywith capital structure, ie the split between debt and equity capital. Whether or not thisthe case is a matter of dispute and is likely to depend upon the various characteristics ofC IFE: 2009 ExaminatiThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Page 5If the Wacc does vary with the level of gearing, then the optimal capital structure willbe that which minimises the WACC- the cost of financing the pany's projectsand hence maximises the value of the pany. It is this optimal and minimum WACCthat should then be used to value the panyIf the proposed project has the same degree of systematic risk as the existing panywhich can be thought of simply as a portfolio of projects- then its undertaking will notchange the pany's overall degree of systematic risk. Consequently, if the riskcharacteristics of the pany are unchanged, then so should be the rates of returnrequired by investors in the pany and hence also the WACC. It is therefore thisminimum level of waCC that should be used to value new projects with the samedegree of systematic risk as the existing panyIt can be argued that this should be the case regardless of exactly how the project inquestion is to be financed. The decision to finance the project-or indeed the panyas a whole -in a manner that is inconsistent with the pany's minimum WACC isindependent of the choice of WACC used to discount the cashflows from the projectand should not therefore influence that choiceThe cost of debt capital should be taken as the cost in real terms of newborrowing by the pany. This is calculated by taking an appropriate marginover the current expected total real return on index-linked bonds, having regardto the pany' s credit rating, and multiplying by(1-t, where t is the assumedrate of corporation taxThis is because interest payments of C say, are paid out of pre-tax profits. Hence theeffective cost to shareholders, in terms of the reduction in the post-tax profits that areavailable to pay dividends, is only(1-rxCThe cost of equity capital should be taken as the current expected total realreturn on index-linked bonds plus a suitable margin to allow for the additionalreturn which equity investors seek to pensate them for the risks they runHere we normally have in mind government index-linked bondQuestion 18. 2What are these additional risks?This gives a real discount rate, to be applied to cashflows expressed in present.day monetary values, or adjusted by the assumed future inflation rate and usedwith cashflows in nominal termsThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 6CT2-18: Capital project appraisal (2)1.2 Allowing for systematic riskAs we learned in Chapter 15, the beta of any asset, such as a pany's shares, isdefined asB=-where o is the covariance between the individual stock ,'s return and that of the marketand om is the variance of the market index. It is a measure of the systematic risk inherentin the asset. Betas can be estimated from historical data on investment retumsThe beta measure relates to the pany's(or industrys)existing activities. Weneed to consider whether the risk associated with any proposed project isconsistent with the pany' s existing risk profileThis is because the appropriate cost of capital to use in decision making is the rate ofreturn offered by equivalent investment alternatives, ie with the same level of systematicNote that by "the risk associated with any proposed project" we do not mean the(diversifiable) specific risk regarding the project,'s oute. If we are unsureabout our cashflow projections, we need to refine them and to make allowancefor possible unfavourable outes in calculating the expected cashflows thatwill be discounted. Such uncertainty is not incorporated into our analysis bysimply increasing the value of beta(and the resulting cost of capital)systematic risk higher than is usual for its projec g a project with a degree ofSuppose, however, that the pany is consideritSystematic risk"is that part of the return on a project that cannot be eliminatedby investing in the same type of project many times over, nor by diversificationbecause investing in a number of projects cannot reduce this part of thevariability to zero. Systematic risk can vary from one project type to another.Systematic risk should be allowed for by varying the discount rates used in theThus if the systematic risk for a particular project is thought to be higher than is usualfor a pany's projects, the discount rate used should be greater than that whichthe pany normally employsFor example, an international pany might apply a higher discount rate toprojects located in countries with unstable political regimesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Page 7A suitable upward adjustment is therefore made to the cost of capital discussed above inorder to reflect the higher level of systematic risk. There is more than one way ofdetermining the value of the adjustment to be appliedLook at other paniesOne guide might be to consider the discount rates which would be appropriatefor use by any panies which habitually engage in such projects, using theabove methodology. In practice such data may be hard to obtain and there maybe no alternative but to make an arbitrary addition to the discount rateAnother problem here is that those panies that habitually engage in such projectsmay have more a greater experience of such projects and hence be better able to mitigatethe inherent risks involved. If this is the case, then a slightly higher discount rate thanthat used by other panies might actually be appropriateCAPM-based approachThe CAPM model can be used to estimate the returns required from different capital assets(including a capital project). The following equation relates the required return on anyasset or project p to the return on the marketrp=r+Bp(m -rr)whereBpand opm is the covariance between the individual projects return and that of the market,is the risk-free rate of return and r is the market returnThis required rate of return can then be used as a risk discount rate to price the projectThe project beta measures the systematic risk of the project and thus the above equationwill give a higher/lower risk discount rate for projects with a higher/lower level oftematic riskNote that CAPM and the security market line are discussed in more detail in Subject Ct8The Actuarial Education CompanyC IFE: 2009 ExaminationsPage 8CT2-18: Capital project appraisal (2)Factors influencing beta in practiceWe would expect to adjust our historic value of beta when we feel that investorswould see the project as being more (or less)risky than the typical panyventureIf for example a pany were to analyse all new projects at its current WACC, it mayfind that a large number of rather risky projects seem to be satisfying the hurdle and allsafe projects are failing. This is only to be expected as risky projects will necessarilyoffer a higher expected rate of return, and give a positive NPV using the pany'sHowever, if the pany were to continue undertaking such projects, believing that theextra return will benefit the shareholders it will find that its shares will not rise in valueThe reason being that the riskiness of the shawill rise as the new risky projects areadded to the portfolio and the shareholders' required return will rise in line with theactual returnsIn other words, shareholders will get higher returns, but they will simultaneously requirehigher returns!Ultimately, this will be a matter for judgement, but issues to consider includecyclicality-does the oute of the project depend strongly on the stateof the economy and the business cycle?operating leverage - does the project involve a high proportion of fixed(as opposed to variable) costs?Positive answers to either of these questions will suggest a higher value shouldbe used for betaAt every stage of the economic cycle people need to eat, hence the profits of a largesupermarket chain will not be as exposed to the economic cycle as those of a hotel chainor a pany offering luxury goods. This is what we mean by"cyclicality". Someindustries simply have higher systematic risk by natureOperating leverage has a similar effect to financial leverage. If a project has high fixedcosts, the return from that project will be more volatile than the return from a similarproject with variable costs. A similar result is obtained if a pany has costs that canbe“ disposed of” when times are bad.For example, if a pany has a high proportion of temporary staff, it can reduce itscosts when turnover falls. Hence, although the pany appears to have high fixedcosts, they are in fact variable in natureC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Page 91.3 Practical experienceThe "Target Practice"survey found that nearly one third of panies appliedthe same cost of capital to all projects This can lead to wrong decisions beingmade if the systematic risk of different projects is substantially different. Thisill particularly be the case if the pany involves itself in a project outside itsusual area of activity. In these cases, a project beta should be estimated fromwhich a project cost of capital can be derivedQQuestion 18. 3The equity shares of a pany have a beta of 1. The pany is considering a projectwhich will double the size of the pany and requires extra equity finance. Theproject is also expected to be twice as risky as the market at present. In deciding whatrate to use when evaluating the project, which of the following two possible approachesshould the pany adopt?Calculate the beta for the project alone, and use this beta along with the marketand risk-free rates of return to reach a rate of return for the projectb Analyse the pany as a whole, considering how the pany will look after ittakes on the project (ie incorporating the new project into the pany's overallportfolio of projects ) Estimate the beta of the resulting pany, and use themarket and risk-free rates of return to estimate a new overall cost of capital forthe pany. This rate should be used to evaluate the projectIt hasfound that use of differentof capital can lead to internalfriction within a pany and this (and siity) is the likely reason why thetheoretically correct approach is often ignoredQuestion 18.4Why might the use of different costs of capital for different projects lead to friction?The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)1. 4 Other factors to considerIt is not unmon for panies to use very high discount or hurdle rateswhen appraising proposed projects. However, the use of a discount rate whichis too high could distort the relative weights placed on the short term and on thelonger term, thereby leading to mistaken decisionsa higher discount rate places lower relative weights on cashflows farther into the futureIts use may therefore lead to, or indeed reflect, too ""short-termist "an approach to capitalprojectsIt may be assumed, mistakenly, that the deliberate use of a very high discountrate provides a contingency margin which reduces the need for a rigorous riskanalysis. However, this leads to the danger of the incorrect acceptance of arisky project with a high apparent NPV or the incorrect rejection of a low-riskproject with a negative NPV, which would have a positive NPv if this werecalculated on a lower but more appropriate discount rateQuestion 18.5Consider two projects, A and B, each of which requires an initial investment of 100Project A produces a certain cashflow of 300 in 5 years'time. B yields a series of levelcashflows at the end of years I to 5 inclusive, the value of which is equally likely to be 0or 90. Which project is the more suitable investment if the appropriate risk discountrate is 15% pa?Suppose instead that a risk discount rate of 20% is used. Which project would then beSUpreferred?Thus, grossly distorted discount rates are inappropriate and could bedangerous. On the other hand, too much precision is unnecessary since theresults of NPv calculations are not usually very sensitive to small changes ofsay, 1% pa in the discount rate. In any case it would usually be appropriate tocarry out the NPv calculations on two alternative discount rates (say 6% and10% pa real), and if both results are satisfactory, then there is no need to worrytoo much about determining the most appropriate discount rate precisely.Question 18.6How should a pany choose a suitable discount rate to evaluate a project?C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)2 Risk analysis-an overviewWith any project there are risks and these can be divided into two types:1. Systematic: in the system"and which affect the whole area of thebusiness into which the project falls, eg price of land for a buildingproject2. Specific: "specific to the project"and which can be diversified away bythe pany, eg the risk of a cold summer reducing ice-cream salesdiversified by also selling hot dogs.We have seen how the discount rate should allow for systematic risk. Risksspecific to the project should be determined by a risk analysis of the project. Inpractice it may sometimes be difficult to determine into which of these twocategories a risk should fall, but the temptation to classify too many risks assystematic to reduce the analytical work should be resistedWhen we use the word risk we mean either an event which leads to avariation from the most likely oute in either direction (eg the risk of thestructure collapsing) or the probability of occurrence of such an eventMany risks are"downside", in that they involve a worsening of the oute ofthe project if they occur, but the analysis should also take account of possibleupside variations in the same way. For example, there may be a"risk"that sales arehigher than anticipated because of an economic upturnIf, however, we are more concerned with downside than upside risk, then we may wishto allow for this in our risk analysis, perhaps by attaching a greater weight to"bad"thanED: In order to deal with the risks inherent in a given activity, we first need toidentify them. We then need to analyse them, by estimating the frequency ofoccurrence and the consequences if they occur. We must then consider thepossibility of mitigating the downside risks, by reducing the frequency ofoccurrence or reducing the adverse consequences if they do occur, or bothThe next step is to consider the costs of possible mitigation options, to seewhether they are financially viable or not, and then to select the bestbination of mitigation options. The remaining or residual risks are the oneswhich must be accepted by the sponsors and/or investorsThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 12CT2-18: Capital project appraisal (2)At this point a decision is needed on whether to proceed with the project or not.If so we need to control the residual risks, through a series of measures whichincluderegular monitoring of the risksplans for dealing with foreseeable and unforeseeable crisesappointment of risk custodiansreqular management reviewsQuestion 18.7What are the three main steps that must be taken in order to deal with the risks inherentin a given activity?C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)3 dentification of risksIt is important that all risks in a project are identified and evaluated. Amethodology for Risk Assessment and Management of Projects(RAMP)hasbeen developed jointly between the Faculty and Institute of Actuaries andInstitute of Civil Engineers. This describes how this can be achieved in practiceThe steps necessary to achieve an effective identification of the risks (upside aswell as downside) facing the project can be summarised as followsMake a high-level preliminary risk analysis to confirm that the projectdoes not obviously have such a high risk profile that it is not worthanalysing further, eg there is a 50% chance that it will collapse losing all of theinitial investment. This will normally be done as part of the initial projectappraisalHold a brainstorming session of project experts and senior internal andexternal people who are used to thinking strategically about the longterm. The project team here might include actuaries, accountants, managementconsultants and various other experts depending upon the exact nature of theproject concerned, eg engineers, marketing analysts, puter analysts etcThe aim will be to identify project risks, both likely and unlikely todiscuss these risks and their interdependency, to attempt to place abroad initial evaluation on each risk, both for frequency of occurrenceand probable consequences if it does occur, and to generate initialmitigation options and discuss them briefly.Carry out a desktop analysis to supt the results from thebrainstorming session, by identifying further risks and mitigation optionsusing a general risk matrix, researching similar projects undertaken bythe sponsor or others in the past (including overseas experiences), andobtaining the considered opinions of experts who are familiar with thedetails of the project and the outline plans for financing itCarefully set out all the identified risks in a risk register, with crossreferences to other risks where there is interdependency. High levels ofcorrelation between individual risks will lead to a higher overall variance of theinvestment returns from the project, as the individual risks are less likely tocancel each other outThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 14CT2-18: Capital project appraisal (2)3. 1 Risk matricesThese are helpful in the identification and analysis of risks. By imposing a standardisedstructure on the process of risk analysis, they help to ensure that no factors areoverlooked. The basic idea is to construct a table or tables with different genericcategories and sub-categories of risk as the column and row headingsED One method by which to categorise risks is first according to the cause of the risk andsecondly according to the stage of the project at which the risk arises. These twocategorisations can therefore be used as the column and row headings in the risk matrixSubheadings could then be used to subdivide the risks into more tightly definedsubcategories, eg splitting the natural causes of risk into various types such as weather,earthquake etc.By systematically considering each of the cells of the matrix in turn, theinherent in any particular project can be identified. The matrix allows the projectmanager to examine each risk throughout the duration of the project, and think about therisk causes" that might exacerbate the risk. Having thus identified the various risksind their causes, their characteristics and importance can then be identified anddocumented in the matrix. As the project advances through each stage, the projectmanager can then use the matrix to ensure that the causes of risk are considered andmitigated where they represent a significant riskThe categorisation of risks into different types may also aid with the identification ofinterdependencies. For example, two risks with the same cause, eg an economic causesuch as higher than expected inflation, are more likely to be interdependent, than a riskwith an economic cause and one that results from a natural causeC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)An example of a risk matrix might be as followsCause of riskBusinessEconomicnE8Promotion ofconceptloss of intellectuala Designnon pliant右Projectng approval delayThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)Causes of riskA risk matrix suitable for the above purposes would consist of a square table,with the following column headings relating to cause of risk:oliticalbusinesseconomIcprojectnaturalfinancialcrimeQQuestion 18.8What sub-categories might be included under political risks?Question 18.9Consider a capital project involving the expansion overseas of a financial consultancybusiness. Give examples of the risks this project may faceRisks in the successive stages of the projectThe rows of the table would relate to the risks in successive stages of theprojectpromotion of conceptdesigncontract negotiationsproject approvalraising of capitalconstructionoperation and maintenancereceIving revenuesdemissioningC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Page 17Each of these main headings would have a number of subheadings for example,natural might have sub-columns headedearthquakefire or explosionground conditionsDesign might include the following risks, each of which would have its own roin the tablefailure to meet specified standardsprofessional negligence.The example shown earlier is only a small extract of the whole risk matrix. Each cell inthe matrix would be considered in detail and a note. cross or a remark would be enteredto remind the risk manager of the risk to be considered at that point in timeThe matrix would act as a reminder to the analyst to consider particular types ofrisk which may not have been sufficiently considered. The cells in the matrixcan be ticked off to show whether the risk in question applies to the particularproject, with a cross reference to the appropriate entry in the risk register.Some of the risks identified will probably be such that no realistic estimates canbe made of probability of occurrence or likely consequences, and it may be thatsome such risks can be regarded as being systematic rather than probabilisticand hence already taken into account in the discount rate.However, it should be emphasised that risks of very serious or disastrousevents, however uncertain or however low the probability of occurrence, shouldnever be ignored on the grounds that an allowance has been made for them inthe discount rate. Such risks should always be the subject of searchinganalysis, and any which cannot be eliminated should be highlighted in the finalreportAn example here might be the collapse or bankruptcy of one of the partner panies inThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 18CT2-18: Capital project appraisal (2)Question 18.10Jubiloil plc is considering building a new oil pipeline from Siberia to Japan. Thehaconsulting actuary to identify and analyse the risksinvolved in the project. They are confident that the market for oil is strong and will getstronger as economic growth continues in the Far East. The pipeline will be built underland and sea and will pass through islands en route to Japan. Environmentalists havebeen concerned about the threat of pollution from oil slicks and the threat to anendangered species of whale that feeds on the sea bed under which the pipe will be laidThe area is prone to seismic activity. Jubiloil plc is seeking finance from internationalfinancial institutions including the European Bank for Reconstruction and Development(1 Describe the steps necessary to achieve an effective identification of risks facingJubiloil's project(ii) Describe briefly five major risks facing the projectC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)4 Analysis of risksHaving identified the risks inherent in the project, the next step is to attempt to quantitheir impact upon the financial returns yielded by the project. Before proceeding,however, it is important to make sure that nothing has been missed out of the appraisalprocess thus far. This is one reason why prehensive documentation of every stageof the appraisal is of the utmost importanceOnce the identification process is regarded as plete, the project team willreview the work done to date. This will be followed by an analysis of the risksto ascertain the frequency of occurrence and the consequences if the risk eventoccurs. The analysis will concentrate on the independent risks and regard thedependent risks as consequences of themThe risks could be classified according to four different dimensionsFrequency of occurrence or risk level- the perceived likelihood that theparticular risk will occur. The categories used might, for example, vary fromvery likelyto"very unlikely", with associated numerical values, eg probabilitranges such as“>50%, down to“<0.01%Impact-the effect on the cashflows. The occurrence of a risk with a majornegative impact upon the project could lead to its cancellation. At the other endof the scale, the impact might only be a slightly increased cost or a short delay inpletionDegree of dependence -on other separately identified risks. Categories herecould range from"very high degree"tovery low degreeControllability- the extent to which the impact of the risk can be mitigated oranaged. Here the categories could range from"can be pletely mitigatedto"very uncontrollable". The cost of control might also be considered hereThe risk(s) in each cell of the risk matrix are therefore essentially awarded a score foreach of the above dimensions, and the most important risks in terms of their likelyfinancial impact are thereby identified. In this respect, the most crucial aspect of riskprobably the absolute magnitude of the financial impacta guide to the frequency of occurrence will be obtained by consulting experts ineach risk. It might be possible for the expert to give a probability distribution ofthe risk. The analysis will be supplemented by a study of the statistics available,if any, from other projectsThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)4.1 Financial consequences of risksThe financial consequences if the event occurs will be expressed in present-daymoney values, ie after removing the effects of inflationQuestion 18.11Why are present-day money values used?It will often consist of a range of possible values, for which it may be appropriateto use the mid- point, or perhaps a simple probability distribution for the purposeof further analysis. The result will be discounted to its net present value.In principle, the expected nPv of the risk in question will be derived by summinga series of expected NPVs in respect of all future years covered by the analysisThe expected NPV for a potential future year will be the probability of occurrenceof the event in that year (derived from the estimated frequency of occurrence)multiplied by the NPv of the resulting incremental or decremental cashflow(s)ifthe event occurs in that year.The approach can be illustrated as follows. Consider a particular risk relating to an n-year project. Definenet present value in year t of the cashflows arising given that therisky event occurs in year tappropriate discount factor to calculate the present value at timezero of cashflows arising in year t (reflecting the risk discount ratePtprobability that the risky event occurs in year t=1,.,nThen the net present value of the expected cashflow(s)arising from the risk in year t(given that the risk occurs)is equal toNPV,= C v'and the expected net present value of the particular risk is then found by summing overthe lifetime of the project, namely the years, t=1,., n, to obtainENP=∑P1NP=∑PC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Page 21Additional points to note are that:An occurrence of the risky event in year t, may give rise to cashflows in bothyear t and also in subsequent years. Thus, Ct is the net present value of thesecashflows evaluated in year t. For example, ifcashflow arising in year i=t,., n, as a consequence of the riskyevent occurring in year tThen we might calculate CtasC=∑CnyWe might also estimate Cit from a simple probability distribution of the possiblevalues that the consequent cashflows could take in any year. In practice, anysuch probability distribution is likely to be very simple. Hence a single pointestimate of the possible cashflow, Cit-perhaps the midpoint of the range ofpossible values should the risk occur-is often usedThis approach is versatile, as it allows the analyst to usedifferent values of P, in respect of different future years, reflecting thefact that the likelihood of the risky event may vary over timedifferent assumptions concerning the cashflows that arise should the riskevent occur in any particular year t, reflecting the fact that the financialconsequences of the risky event may vary over time.The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)ExampleConsider a three-year project in which all cashflows are assumed to occur at the end ofeach year and a risk discount rate of 10% pa is used to evaluate the projecta particular risk may occur at the end of one of the three years but it can occur onlonce in the lifetime of the projectIf it occurs at the end of Year 1, which event has a probability of 4, the consequentcashflows are I at the end of each of the three yearsIf it occurs at the end of Year 2, which event has a probability of 2, the consequentcashflows are 2 at the end of each of years 2 and 3If it occurs at the end of Year 3, which event has a probability of 74, the consequentcashflows is 3 at the end of year 3Consider the first possibility; if the risk event does occur at the end of Year l, then thepresent value at time I of the consequent cashflows isC1=1×ν+1×y+1×v2=2.7355The present value of these cashflows at the start of the project is thusNPH=C1v=2.7355=24869If the risk event occurs at the end of Year 2, then the present value at time 2 of theconsequent cashflows is2×p+2×v=3.8182The present value of these cashflows at the start of the project is thusNPv2=C22=3.8182v2=3.1555Finally, if it occurs at the end of year 3. then the present value at time 3 of theconsequent cashflows iC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)The present value of these cashflows at the start of the project is thusNP3=C33=33=2.2539Weighting each of the above by the probability that the risk event actually occurs at theend of each year then gives the overall expected net present value of this particular riskENPV=P,NPV+ P2NPV2+ P3 NPV3=%4×24869+%×3.1555+×2.2539=2.76Care must be taken to ensure that the method of calculating the expected nPv ofeach risk is consistent with the method chosen to calculate a distribution ofNPVs for the project as a whole(see Section 5).The risks will then be prioritised for further analysis. In general the risks withlow expected NPVs will be discarded, with the intention of allowing for them in ageneral contingency allowance later. For example, by means of a one-off globaldeduction from the overall expected nPv of the projectHowever, any risks which would have very serious or disastrous consequencesbut where the expected NPv is low because the probability of occurrence issmall, would be retained for further analysis along with the risks having higherexpected NPVsQuestion 18 12What types of risk eventht have very serious or disastrous consequences, but a lotexpected NPV?Question 18 13For the project described in Question 18.10, describe how the risks could be analysedThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 24CT2-18: Capital project appraisal (2)5 Obtaining a distribution of NPVs in practiceIn Chapter 17 Section 3, we looked at the two principal ways in which a range ofthe NPvs for the project as a whole may be obtained5.1 Scenario analysisThe first is to construct a series of future scenarios, each representing abination of possible outes for the major risk events and each having itown probability of occurrence, obtained by bining the probabilities of thevarious independent ponent risks. The outes selected for the purposeof the scenario analysis will in practice often be the mid- points of a range ofpossible valuesFor example, if there is an 80% chance that the capital cost will lie betweenE40m and E42m, and a 20% chance that it will lie between E42m and E50m onemight model two sub-scenarios, the first having a capital cost of f41m with an80% probability and the other having a capital cost of E46m with a 20%probability. If each of these 2 sub-scenarios for capital cost were to bebined with (say) 4 sub-scenarios on gross revenue and 3 sub-scenarios onrunning costs, we would generate a total of 2 x 4 x 3= 24 scenariosHence, if each of the sub-scenarios has an attaching independent probability ofoccurrence, these probabilities can be multiplied together to obtain the probabilities ofeach of the 24 independent scenarios arising. If we then evaluate the NPV that will ariseunder each of the 24 scenarios, we can weight these NPVs accordingly in order tocalculate the expected NPV of the project as a wholeOne method of obtaining the distribution of NPVs is therefore to estimate separatedistributions of outes forcapital costsoperating costsreceipand then to bine the resulting distributions thus obtained to get the distribution ofNPVsIt is sometimes possible for simple scenario analysis to be carried out withoutusing a puter at all. For each scenario the probability of occurrence and theNPV if it occurs are calculated. Assuming that the scenarios cover all possibledistribution of the NPvs of the projecoutes, at least in principle, the result will be an approximate probabilityC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)ExampleConsider a potential project with a lifetime of five years, in which the initial investmentis 120, and for which the possible outes can be modelled as follows(all netcashflows being received at the end of each yearIn each period the probabilities of obtaining a"high/medium/low"market share of20%715%/10% are estimated to be 74.72 and 4. AlsoThe probability of"high"market growth is estimated to be 74, in which eventtotal market profits/net cashflow(excluding the initial investment) will be 350The probability of medium"market growth is estimated to be in which eventtotal market profits/net cashflow(excluding the initial investment) will be 300The probability of "lowmarket growth is estimated to be 4, in which eventtotal market profits/net cashflow(excluding the initial investment) will be 250Under these assumptions, we can draw up a table as follows, showing the NPv of theproject under each possible oute using a risk discount rate of 15% paMarketMarket share Probability of Net cashflowNPV ofouteof projectouteouteHigh1/1670114.65Highmedium1/852.555.99High2.67Mediumhigh1/86081.13Mediummedium1/430.85Medium18301944high1/1647.61Lowmedium37.55.71Lowlo1/162536.20The Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)The NPV under each possible scenario is found from the equation of valueNPvwhere X is the net cashflow in that particular scenarioThe expected NPV of the project is then found by multiplying each NPV by itsassociated probability and then summing over all possible scenarios-ieNPv×114.65+×5599…+,×(-36.20)=+30.8would appear to be profitable. According to the table, it will in fact be profitak, projeThus, in this case, the expected NPV turns out to be about +30.8, and so the projectof the nine possible scenarios- when a medium or high market slhare is achieved - andwith probability 3/46. 2 Stochastic modellingThe other main method is to build a puter-based stochastic model, in whichthe various risks are modelled and a series of simulations is then run in order toget a probability distribution of the NPVsThis approach may give a better overall feel for the variability of the possible financialoutes. The possible outputs of such a model might include the distributions ofNPVSprofits(or revenues and costs separately) in each future yearevents(eg profitable years and unprofitable years)times to events(eg the time until total receipts exceed total expenditure-the5. 3 Relative merits of the two approachesAlthough it may appear that the second method would be superior, practicalexperience has shown that the number of assumptions which has to be made inunding aften doubtful whether thresults can be relied upon with sufficient confidence to justify the effort andexpense InvolvedC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)When building a stochastic model, the most difficult data to estimate reliably are thecorrelation coefficients linking the various input parameters. It is not hard to imaginethat if your input parameters for a model wereGerman interest rates(2) US inflation(3) the failure of your German market supplier(4) the failure of your US marketing panythen probabilities of each event of each might be hard to estimate in the first placeWhilst the correlation between (1)and(2) might be obtained through analysis ofhistorical financial data, the correlations between(1)and ( 3)would be hard to estimateand between(3)and (4)might be no more than guessworkMore seriously, there is the danger of losing sight of key factors andassumptions in looking at the output from such a model, whereas the effort ofworking up a scenario analysis by hand often forces the analyst to concentrateon the important risks and assumptions. Despite this, however, a parativelsimple stochastic model may well be useful to simulate one specific projectactivity, where the assumptions underlying the model, and its limitations, can bekept clearly in view5.4 Unfavourable NPvsHaving arrived at a probability distribution of NPvs for the project as a whole, itill often be found that some of the resulting NPvs are"unfavourable",ie thare unacceptably low or negative. Some of these unfavourable NPvs may havelow probabilities of occurrence attached to them, and the sponsor may beprepared to accept these risks. In other cases, however the nPv may be sounfavourable that even with a low probability of occurrence it is unacceptable.For example, the financial consequences of an earthquake on a bridge building projectmay be enormous, perhaps even threatening the solvency of the pany. Theconsequent and unacceptably high downside risk, might then mean that the project is notconsidered viable, even though the:project has a positive expected NPVprobability of the risk occurring is very smallIt is for this reason that the assessment of the impact of each risk is particularlyThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)6 Other methods of appraising risky projectsSo far, we have suggested that the specific risk in a project can be evaluated byconsidering the probability distribution of the NPVs. A number of other methods areused to evaluate projects. Two are discussed below:6. 1 Certainty equivalentsThe use of a risk discount rate for establishing the present value of futureproject cashflows bines the two elements of time value of money and thelevel of risk associated with the cashflow. As the level of risk may varyaccording to the nature of the particular item being assessed, we should strictlyuse a different risk discount rate for each element. To avoid this, we replace theindividual (risky) projected cashflows with their certainty equivalents- that isthe projected element of the cashflow adjusted for risk aloneIn this way we produce a series of "certain"cashflows that can then bediscounted at a uniform rate of returnCertainty equivalents can be used to replace the individual risky projected cashflowsand then discounted at a uniform rate of returnExampleSuppose a project will produce two cashflows, one at the end of Year I and another atthe end of Year 2. The cashflows are respectively $10 million and $20 million. Thepany estimates that the uncertainty surrounding the amount of the first cashflow isquite low, but the uncertainty surrounding the amount of the second is relatively highThe pany can eitherdiscount both using some arbitrarily high rate of discount(25% pa? )to reflectthe average level of risk2. assess the value of the certainty equivalent cashflows and discount these at anappropriate rate of return. This might involve decreasing the first payment by5% and the second by 15%, and discounting both at the rate of return of 12% paC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Question 18.14Calculate the two outes for the result in the previous example6. 2 Probability treesOften a project consists of a number of investment decisions spread over time,where the choices available at any point will depend on the decisions made atearlier stages so that the initial decisions made will restrict the future choices(but do not irrevocably bind us to future actions At the same time, laterdecisions can be made with the benefit of earlier experience and of theconditions prevailing at the timeThe probability tree technique allows us to investigate projects that have such astructure, particularly where the estimated probability of future events can berefined in the light of initial experience.We produce a probability tree by1. mapping the possible choices, beginning from the initial project decisionand branching out to represent all the possible subsequent options2. assigning estimated cashflows associated with each future possiblechoiceestimating the probabilities associated with each future cashflow4. using standard expected value calculations, incorporating both the timevalue of money and the probabilities, to assess the optimal choices ineach future time period based on the knowledge of the intervening eventsworking backwards from the latest decision point to the present day inorder to establish the best (ie highest NPV) route to follow at the outsetProbability trees can be used to model projects where the choices available at any pointin time will depend on the decisions made at earlier stages of the projectAn example of such an analysis follows, based on the construction of an office block (ifpermission is granted) on a plot of land that is available for purchaseThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)This type of analysis lends itself to projects where clear-cut events occur and newinformation is gained as the project progresses. After each of these events has passed, itwill be possible to assign better probabilities and NPVs to the subsequent branches inthe light of the information gained. It might also be possible to reassess branches thathave not been chosen to see if the decision was correct -although if there is no chanceof revisiting the decision it is seldom worthwhileExampleA pany can purchase a plot of land for t5 million, following which it will apply forvarious types of planning permission. The pany has a number of options availableto it. Each stage of the project might take 6 months to a year to plete, and decisionshave to be made at the end of each stageThe diagram opposite shows the probability tree that describes the options.Analysing the outes assuming that office permission is granted we can see that it islikely that the pany will build a large office block. The potential profit from a largeoffice, assuming that there is an 80% chance of finding tenants, is(80%×20+20%×3)=£16.6 millionwhereas that of a small office is(80%×12+20%×6)=£10.8 millionOn the assumption that a large office will be chosen, the potential worth of the entireproject, including the outes if office permission is rejected, is60%×166+40%×(90%×8+10%×2)=£129 millionIncluding the initial investment of t5 million for the land this will lead to an expectedE7.9 million profit overallAfter 6 months, when both the planning permission and the results of the tenant searchare received, another decision can be made. Let us suppose that permission has beengrantedThe pany will now have to decide whether to build a small or a large office. On thebasis of its market research it may adjust the probabilities of finding a tenant beforetaking the next step. If the probabilities are now assessed to be 20% in favour of findinga tenant, and 80% against then the decision would be turned on its head. and thepany would be advised to build a small office plexC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Page 31or a small officePotential tenant found (80%) Sell office fully let(if large office, NPV£12 million)large office npⅤ£3 million; if smallBuy land at cost ofApplyfor plapermission toBegin looking forpotential tenant for aId residentialhousing (npv= f8million)Apply for residentialhousing permissionResidential permission rejected(10%) an industria G£2 million)Figure 1: Probability tree for construction projectThe Actuarial Education CompanyC IFE: 2009 ExaminationsPage 32CT2-18: Capital project appraisal (2)The following two sections on risk mitigation and the investment submission do notcontain any new Core Reading. Section 2 of this chapter gave an overview of the wholeprocess of dealing with risk and Sections 3, 4 and 5 gave details of some of the stagesinvolved in the process. The following two sections plete the picture. You mightfind it interesting, though it is not pulsory reading! If you decide to give it a missreturn to the notes on page befor a final question covering the whole of the projectappraisal procesC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)7.2 The financial consequences of risk mitigationThe result of adopting a particular option ought to be to reduce the downward volatilityf the NPVs but in addition it will normally eitherincrease the expected npv. ordecrease the expected nPvIn the former case, the mitigation option is entirely beneficial and should be built in tothe project. This is because risk has been reduced and expected return increasedConsequently the project has been unambiguously made more attractiveIn the second, and more normal, case, judgement will have to be exercised on whetherthe mitigation option in question should be adopted. In this more usual case, risk hasbeen reduced at the expense of a reduction in expected returnIndeed it will be a matter for judgement, which is the best bination of mitigationoptions, so as to achieve the most acceptable resulting distribution of NPvs. Thisshould have regard not only to the views of the sponsor but also the likely reactions ofprospective lenders and investors- remembering that the lenders in particular will bemore concerned with downside than upside variability.QQuestion 18.16examples of how the risks associated with this project might be mitigate atform.GiveConsider a capital project involving the upgrading of an office It plaC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)8 The investment submissiona decision will now need to be taken on whether the project should proceed. Theinvestment submission which is to be used as a basis for this decision should assumethat the best possible bination of mitigation options will be implemented. It shouldshow the expected NPV (allowing for both upside and downside risk and for anappropriate contingency margin to cover probabilistic risks which have not been fullyanalysed) and the probability distribution of NPVsThe residual risks should be fully identified and analysed, and particular attention paidin the submission to any remaining risks which (even if they have a low or uncertainprobability of occurrence) could have a serious or catastrophic effect on the oute ofthe project as a whole. The method by which it is proposed to finance the projectshould be specified, and an analysis provided showing the likely effect on investors aftertaking account of expected price inflation, borrowing, tax, etc.2= The aim of the investment submission should essentially be to discuss how the projectrelates to the sponsors criteria for judging whether or not to proceed with a projectQuestion 18 17List the six main criteria against which the sponsor may judge whether or not toundertake the projectThe decision makers will need to pay attention not only to the submission but to a rangeof intangible considerations which are necessarily outside the scope of the formalanalysis. Such considerations might includeallowance for any likely bias or possible approximations in the estimates"hunch"-any gut feelings or instincts that cannot be quantified, perhaps basedon previous experience. Care should be taken, however, to ensure that these donot override the results of the formal appraisal processnowledge not in the possession of those who have prepared the submissionlast-minute developments- that have arisen since the preparation of theubmission documents, including any new information that has e to light,doubts about feasibility or quality of implementationoverall project credibility, etcThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)They will also wish to consider whether the upside potential has been estimatedrealistically. Finally, judgement will be required on whether, taking all these aspectsinto account, the project meets the sponsors criteria(see Section 2) sufficiently tojustify a decision to proceedIf the decision is to taken to proceed with the project, then it is important that all aspectsof the project are reviewed regularly, to assess its ongoing profitability. Comparison ofIctual outes with those projected within the project appraisal also enables theupdating of the appraisal assumptions and will assist with better future modelling ofboth this and other projectsShould the project be rejected, it is important to bear in mind that circumstances maychange in such a way that it bees appropriate to start the project at a later date. Forexample, an economic upturn may enhance the projected profitability of the project tothe extent that it is deemed viable at a future dateThus, in each time period we could think of the decision to be made as a choicebetweenstarting the project nowdeferring the start of the project until at least the next time period, at which pointwe will revisit the choice in the light of the conditions then prevailingQuestion 18.18Describe the stages involved in the project appraisal procedureC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Page 37Chapter 18 SummaryCalculating the required rate of return for a projectThe use of the cost of capital to calculate the net present value in screening projectsensures that projects are only entered into that will enhance the return to shareholdersprovided that it is adjusted to reflect the project risk. The required rate of return shouldtherefore reflthe weighted average cost of capitalthe degree of systematic risk associated with the projectThe weighted average cost of capital can be calculated asMarket value of debtWACC=x net cost of debtMarket value of debt +equityMarket value of equityCost of equityMarket value of debt +equitySystematic risk is that part of the return on a project that cannot be eliminated byinvesting in the same type of project many times over, nor by diversification. Thesystematic risk of a project p is measured by beta, which is defined asBpIf the systematic risk for a particular project is thought to be higher/lower than is usualor a pany's projects, then in theory the discount rate used should be greater/lowerthan that which the pany normally employsAdjusting the discount rateA suitable adjustment to the discount rate might be based onlooking at the discount rates appropriate for use by any panies whichhabitually engage in such projectsan arbitrary additionthe degree of cyclicality associated with the projectthe operating leverage of the projectThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)Dealing with specific risksRisks may be upside as well as downside In order to deal with them we need teidentify themanalyse themmitigate the downside riskscontrol any residual risksThe steps necessary to achieve an effective identification of the risks includeundertaking a high-level preliminary risk analysis, holding a brainstorming session,carrying out a desktop analysis, setting out all the identified risks in a risk register, andensuring that upside risks as well as downside risks are coveredA risk matrix can be used to systematically identify risks categorised according to thecause of risk and the stage of the projectCauses of risk can be classified as political, business, economic, project, naturalfinancial and crimeThe stages of a project include promotion of concept, design, contract negotiationsproject approval, raising of capital, construction, operation and maintenance, receivingrevenues and demissioningThe analysis of risks aims to ascertain the frequency of occurrence and theconsequences if the risk event occursIn order to judge the financial consequences of each risk, the expected NPV for eachrisk can be calculatedObtaining a distribution of NPvsa probability distribution for the NPvs for the project as a whole can be obtained usingeither scenario analysis or stochastic modellingOther methods of dealing with risky projectsCertainty equivalents can be used to replace the individual risky projected cashflowsand then discounted at a uniform rate of returnProbability trees can be used to model projects where the choices available at any pointin time will depend on the decisions made at earlier stages of the projectC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Chapter 18 SolutionsSolution 18. 1The funds required to service the debt of a pany are deducted from the profit beforetax, and therefore reduce the amount of tax a pany has to pay. Viewing this from adifferent angle it can be said that the government is in effect paying to bond investors anamount equal to the tax on the fixed interest debt paymentsIssuing debt is a more tax-efficient way of raising capital than raising equitySolution 18.2The main additional risks are theuncertainty relating to the level of future ine paymentsdditional volatility of the share price as pared to index-linked bondadditional default risk of the shares, with regard to the ine and capitalpayments, as pared to index-linked bondslack of perfect inflation protectionSolution 18.3Each undertaking must be valued on its own merits. If the project involves twice themarket risk, then it should only be undertaken if it offers the appropriatereturn, ie the return that would be required if the project stood in the market as aseparate entity. Option a is the only one that offers thisSolution 18. 4It might lead to friction because different rates of return could mean the go-ahead or theshelving of various projects. These rates would have to be determined by managementand views on the riskiness or not of a project might not be consistent between managersFeelings could be hurt and accusations of politics would emerge if certain projects wereallowed to proceed purely because of the use of a lower risk discount rateThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)Solution 18.5With a risk discount rate of 15%o, the NPv of project A has a certain value of 49.2whereas the NPv of project B takes values of -100 and 201.7 with equal probabilityHence, b has an expected nPv of about 50.8. Thus, b has a slightly higher expectedNPV, but in view of the much higher level of risk involved, a may well be the moresuitable investment. A fairer parison would use a higher risk discount rate for B, inorder to reflect the extra risk involvedIf 20% is instead used, then the numbers bee 20.6 for project A and 34.6 for BThus, the higher risk discount rate leads to an even stronger preference for the morerisky project- because the duration of the cashflows is shorterSolution 18.6The starting point in this decision must be the weighted average cost of capital(WACC). The WACC is the weighted average of the returns required by investors onthe debt and equity of the pany. It represents the opportunity cost of the resourcesinvested in the pany, ie what the resources could earn in a similarly risky venture. Ifwe discount cashflows from a project at the WACC, then a positive net present valuemeans that the project would increase shareholders' wealthSince the WaCC will be affected by gearing, the pany should use the wacC at itsoptimal capital structure, regardless of how the project is actually financed. Thisseparates the financing decision from the investment decision. (If the panys capitalstructure is not optimal, it could be made optimal through a separate decision.If the proposed project has the same degree of systematic risk as the pany as awhole, then the WaCC is the appropriate discount rate to useHowever, if the degree of systematic risk is different from the pany as a whole thenthe WACC should be adjusted up or down to reflect the higher or lower degree ofsystematic risk of the project pared with the average of the panys projectsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Page 41The discount rate could be found byreference to past similar projectsreference to the discount rate used by panies that usually invest in this sort ofproject(though allowance must be made for any differences in gearingusing an estimated beta for the project B, and the capital asset pricing modelwhere the required return from the project isrp= risk-free return+(Pp x equity risk premiumand the beta of the project measures the covariance of the project returns andmarket returns as a proportion of the variance of market returnsThe beta of the project will be affected by the cyclicality of the project returns( do the returns depend on the state of the economy and the business cycle? )andoperating leverage(does the project involve a high proportion of fixed costs?)Solution 187The three main steps that must be taken in order to deal with risks areidentify the riskanalyse the risks- by estimating the frequency of occurrence and the financialimpact should a particular risk occurmitigate the risks- in order to reduce the frequency of occurrence and thefinancial impact should a risk occurSolution 18.8The sub-categories could includegovernmentpublic opinionenvironmental objectionslegislationwars. crime etcpublic relationsThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)Solution 18. 9There is no uniquely correct answer here. Possible examples could includepolitical risk arising from a lack of co-operation from the overseas governmentand financial regulatorsbusiness risk arising from a lack of experience of the way business is conductedthe overseas countryeconomic risk arising from a slowdown in economic activity in the overseasSolution 18.10(i) Identification of riskThe steps necessary to achieve an effective identification of the risks(upside as well asdownside risks) facing the project can be described as followsobviously have such a high risk profile that it is not worth analysing furthernotHigh-level preliminary risk analysis to confirm that the project doesBrainstorming session of project experts, eg actuaries, accountants, managementconsultants, oil expertsThe aim will be to identify all project risks and make an initial judgement oftheir likelihood, severity and interdependencyDesktop analysis to supplement the above by identifying further risks(using arisk matrix), researching similar projects, and consultation with expertsSet out all the identified risks in a risk register, with cross references to otherrisks where there is interdependencyC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)(ii) Five major risks facing the projectPolitical risks, eg some governments might be hostile to the pipeline and maynot allow the pany to pass through its borders or they might imposeconstraints or additional taxes on pany. Environmentalists concerned aboutpollution and wildlife might disrupt the projectdelay the building from earthquakes and bad weather, eg typhoons, coulddelay the building of the pipeline, could destroy it or could cause widespreadpollution and destruction of wildlifeProject risks arising from the level of difficulty in construction of the pipelinebeing greater than anticipated or the failure of technologyFinancial risks arising from the difficulties in raising finance and the possiblewithholding of funds until concerns of the financiers have been addressedThe economic risk associated with unpredictable and possibly large changes inthe world oil price from its current level, and also from unpredictablefluctuations in the value of local currencies (in which local costs aredenominated)and in the US dollar(in which oil is priced), both against sterling(the domestic currency)Solution 18.11Present-day money values are used for the financial consequences because futurecashflows are easier to interpret if they are expressed in terms of current money valuesFor example, it may be easier to appreciate the size of a cashflow in 5 years time if it isexpressed as f100 in today's money as opposed to f130 in 5 years'time's moneySolution 18.12The types of risk events that might have very serious or disastrous consequences but alow expected NPv includeextreme natural disasters such as earthquakesextreme stock market collapses. which might have a severe impact on thefinancing of a projectextreme political risks, such as the outbreak of warThe Actuarial Education CompanyC IFE: 2009 Examinationse44CT2-18: Capital project appraisal (2)Solution 18.13The risks that are identified can be analysed according toThe frequency of occurrence or risk level, ie the perceived likelihood that theparticular risk will occur.The financial impact, ie the effect on cashflowsThe degree of dependence- on other separately identified risksControllability, ie the extent to which the impact of the risk can be managedThe analysis is conducted in conjunction with experts in each risk and using anyavailable statistics on similar past projectsThe financial consequences if the event occurs are normally expressedin present-day money values, ie after removing the effects of inflationin terms of a range of possible valuesThe results are then discounted to give net present values (NP Vs)using a real riskdiscount rate. Where a range of values is given with a probability distribution, theexpected net present value figures can be foundrisks will then be prioritised for further analysis. In general the risks with lowted NPVs will be discarded, with the intention of allowing for them in a generalcontingency allowance later, for example, by means of a one-off global deduction fromthe overall expected NPv of the projectHowever, any strategic risks that would have very serious or disastrous consequencesbut where the expected NPV is low because the probability of occurrence is small egearthquakes or other infrequently occurring extreme natural disasters, would be retainedfor further analysis along with the risks having higher expected NPVsC IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Solution 18, 14Discounting at 25% gives10201.251252£208 millionUSing certainty equivalent values gives10×09520×0.85=£22.0 millionSolution 18, 15Six possible methods by which to mitigate risk includeavoiding the risk, eg by redesigning the project. In certain circumstances theonly way to avoid the risk may be by not proceeding with the projectreducing the risk, by either reducing the probability of occurrence or theconsequences or both, eg by modifying the design or building in safety marginspi3. reducing uncertainty, eg through further research or a feasibility study -to gainmore precise estimates of the possible future cashflows or the impact of each4. transferring risk, eg by engaging a sub-contractor on a fixed price contractnsuring risk- by paying a premium to pass on some of the risk to an insurancepany.6. sharing risk with another party, especially where the other party is able to controthe risk to some extent. For example, a project might be undertaken as part of asyndicate rather than in isolationSolution 18.16Again there is no one correct solution. Examples of the sorts of ideas you may haveenerated areReducing the risk, eg by refining the plan and performing the upgrade in phaseshopefully enabling any problems to be identified and addressed on a smallerThe Actuarial Education CompanyC IFE: 2009 ExaminationsCT2-18: Capital project appraisal (2)Reducing uncertainty via further research to gain more precise estimates of thepossible likelihood and impact of each risk, eg by contacting other users of theintended hardware and/or software to investigate any issues they have facedTransferring risk by employing external consultants to perform the upgrade onterms that include technical support and backup if problems occurSolution 18.17The six main criteria against which the sponsor may judge whether or not to undertakethe project were discussed in the previous chapter. They arethe expected financial resultsthe financial risks3. achieving synergy or patibility with other projects undertaken by the sponsor4. satisfying political constraints", both within and without the sponsoringorganisationhaving sufficient upside potential6. using scarce investment funds or management resources in the best waySolution 18.18The project could be appraised using the following stepsInitial appraisalWe would first need to make a feasibility study to determine whether the project isworth appraising in full. We would need to see if the project satisfied the projectsponsor's requirements before advancing to the next stage.C IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-18: Capital project appraisal (2)Page 47There will be financial criteria to meet, (eg is the project likely to earn a hurdle rate ofreturn? )and also non-financial criteria, includingplitical objectives- is the project acceptable or desirable to the sponsors, seniormanagement and other interested partiesupside potential-is there enough of it to make the project worthwhile?synergy- does the project achieve synergy with other projects undertaken by thesponsor?opportunity cost- is the project the best use of scarce investment funds ormanagement expertise?If it satisfies the requirements above, we would undertake a detailed appraisalDetailed appraisalDefine the project and its scope to ensure that the projects objectives and theroles and responsibilities of the project team are clarifiedEstimate cashflows by estimating the most likely cashflows for revenues, initialcapital expenditure, running costs, termination costsEvaluate cashflows by measures such as the net present value (NPv), internalrate of return (IRR), discounted payback period and receipts-costs ratio. Tocalculate the npv. determine a suitable discount rate. The discount rate shouldreflect the systematic risk of the project. Sensitivity testing could be performedto check the sensitivity of the results to the assumptions, eg the initial capitalexpenditure the discount rateConduct a risk analysis. Identify all risks(upside and downside) by usingbrainstorming and desktop analysis techniques. From the risk matrix, analyseeach risk with respect to frequency, severity, interdependency and mitigationoptions. Calculate the expected NPVs of the risksEvaluate cashflows allowing for the specific risks of the project. Obtain adistribution of NPVs for the project by scenario analysis or stochastic modellinInvestment submissionWrite up all the above in the investment submissionThe Actuarial Education CompanyC IFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2-19: GlossaryChapter 19GlossarySyllabus objectivesG Demonstrate a knowledge and understanding of the principal terms in use ininvestment and asset management0 ntroductionThis final chapter defines the principal terms used in investment and asset managementSome of these terms you will be familiar with and some relate to concepts that will beelaborated in later subjects, particularly Core Applications and ST5. You may wish torefer back to this glossary at a later stagThe Actuarial Education CompanyIFE: 2009 ExaminationsPage 2CT2-19: Glossary1 Glossary of principal termsAccrued interestThe amount of interest that has accrued on a bond since the last couponayment. If a bond is quoted ex-dividend, accrued interest is negative.American optionAn option that can be exercised on any date before its expiry.Arbitragedifferentially priced portfolios so as to make a risk-free prof ally equivalent butThe simultaneous buying and selling of two economically equivalent butBear marketA period of time during which investors are generally unconfident and stockmarket prices decline. (Compare with bull market.Bearer documenta document that proves ownership of a security and where the interest and theredemption proceeds must be claimed by the bearer or holder. There is noregister of the owners of the security.BenchmarkA standard or model portfolio against which a fund's structure and performancewill be assessedBeta valueA measure of a stock's volatility relative to movements in the whole marketUsually defined as the covariance of the return on the stock with the return onthe market, divided by the variance of the market returnBid priceThe price at which a market maker offers to buy a security.C lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: GlossaryPage 3Bill of exchangea bill of exchange is an invoice which is endorsed by an investment bank andwhich can be sold to a discount house to raise short-term finance Where theendorser is an"eligible"bank the bill is known as an"eligible bill of exchangeIn the case of an"eligible bill"the bill of exchange is a very secure investment.BulldogA sterling denominated foreign bond issued by an overseas borrower in thetraditional uK bond marketBull markeA period of time during which investors are generally confident and stock marketprices increase.(Compare with bear market.Callable bonda bond containing provisions that allow the issuer to buy it back atpredetermined price at certain times during its life. (Compare puttable bondCall optionThe right, but not the obligation, to buy a specified asset on a set date in thefuture for a specified price.(Compare with put optionCapital coverA calculation made for loans issued by panies. The capital cover is thenumber of times that the assets of the pany(excluding intangibles and afternotionally paying current liabilities)cover the amount of the loan (including priorranking loansCash settlementA procedure for settling a futures or options contract in cash rather than bydelivering the underlying assetCertificate of depositA certificate issued by a bank showing that a stated sum of money has beendeposited for a specified time at a specified rate of interest. Certificates ofdeposit can be traded (ie sold) by the original depositor.The Actuarial Education CompanyIFE: 2009 ExaminationsCT2-19: GlossaryChinese wa∥sRegulations intended to prevent conflicts of interest in integrated security firmsClean priceThe price of a bond without allowance for accrued interest. (Compare dirtyprice.Clearing houseA firm that guarantees the performance of the parties in an exchange-tradedderivatives transactionCommercial papera generic term for short-term debt issued by panies. (The terms"paper"ornotes" are often used when referring to short-term debt. Commercial paper isa single name form of short-term borrowing used by large panies. It esin the form of bearer documents for large denominations which are issued at adiscount and redeemed at par.Convertible securityA security which may be converted into something else(usually into shares inthe same pany)on specified terms.Corporation taxTax on pany profitsCounterpartyThe opposite side in a financial transactionCouponThe(usually six-monthly) interest payments on a bondC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: GlossaryPage 5CovenaAn agreement that is legal and binding on the parties involved. the expressionis often used in association with corporate debt, because the borrower is boundto the terms of the agreement. the expression is also used in propertyinvestment because the tenant or lessee is bound to the terms of the leaseagreement. In fact the meaning of covenant has been extended in the context ofproperty investment so that it usually refers to the quality of the tenant, eg atenant with a good covenant is a good quality tenant who is unlikely to break theterms of the agreementCredit ratingA rating given to a pany's debt by a credit-rating pany as an indicationof the likelihood of default. Top rating is usually AAA. Credit ratings are muchused and are generally highly reliableCredit riskThe risk that the counterparty to an agreement will be unable or unwilling tomake the payments required under the agreementCum-dividendThe state of a security where the purchaser of a bond or share is entitled to thenext coupon or dividend. Opposite of ex-dividend.CustodianThe keeper of security certificates and other assets on behalf of investorsDealing costsThe usual expenses of dealing in securities- mission, stamp duty and anyregulators'leviesDebentureA loan made to a pany which is secured against the assets of the panyDebentures usually have a floating charge over the assets of the pany sothat debenture holders rank above other creditors should the pany bewound up Debentures with fixed charges are called mortgage debenturesThe Actuarial Education CompanyIFE: 2009 ExaminationsCT2-19: GlossaryDepreciationAn accounting convention whereby firms write down the value of their assetsover timeDerivative instrumentA financial instrument with a value dependent on the value of some other,underlying assetDirty priceThe price of a bond allowing for accrued interest. (See clean price.Dividend coverThe number of times that the dividend payments are covered by earnings for therelevant period. Defined as: earnings per share +dividend per share. It is theinverse of the payout ratio. Care needs to be taken that the tax treatment of theearnings and dividend figures are consistentDividend yieldThe running yield(dividends+share price)on an equityEmerging marketStock markets in developing countries such as China, Mexico, Singapore etcThey offer high expected returns due to rapid industrialisation. They are alsovery risky marketsEuro bondAn international bond issued by a pany or government, often in a currencyother than the currency of the borrower The bonds are traded internationallythrough banks, and not in the traditional bond marketsEuropean optionAn option that can only be exercised at expiryC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: GlossaryPage 7EX-dividendWhere the purchaser of a bond or equity is not entitled to the next coupon ordividend payment. Instead the seller receives the next coupon or dividendpayment. ( See cum-dividend.Exercise priceThe price at which an underlying security can be sold to(for a put)or purchasedfrom(for a call the writer or issuer of an option (or option feature on a security)Also known as strike priceFair pricesMarket prices that are impartial to both buyer and seller. Often determined byFinancial gearingThe expression "gearing"or"financial gearing"is often used to refer to theimpact on the profits for a pany caused by fixed-interest borrowing. For afinancially highly geared pany a small change in the total profits might haven the profits for shareholdwith lots of fixed-interest borrowing is"highly gearedFixed chargeThe assignment of specified assets of a pany or an individual as security fora debt. (Compare with floating chargeFloating chargeThe assignment of all the assets of a pany or an individual as security for adebt.(Compare with fixed charge.Floating-rate note(FRNA Eurobond with a variable rate of interest. FRNs are usually medium-termbondsForward contractA contract to buy(or sell) an asset on an agreed basis in the futureThe Actuarial Education CompanyIFE: 2009 Examinations8CT2-19: GlossaryForward interest rateThe m year forward rate at the start of year n is the interest rate expected toapply for m years from the start of year nFree floatThat proportion of the equity of a pany available for trading by the public ona stock marketFreeholdThe freeholder of land is in practice the absolute owner of it in perpetuityutures contractLike a forward contract, this is a contract to buy (or sell) an asset on an agreedbasis in the future. However. futures contracts are standardised contracts thatcan be traded on a recognised exchangeGearingThe ratio of debt to equity. Often referred to as financial gearingGilta debt security issued by the british government that pays regular couponsHedgingAction taken to protect the value of a portfolio against a change in market prices.Hedging involves holding offsetting positions in assets or portfolios the valuesof which are expected to respond identically to market changesHurdle rateA target or minimum rate of return used in Capital Project assessmentImmunisationEnsuring that the discounted mean term of assets equals that of the liabilitiesand that the spread of the assets is greater than the spread of the liabilities. Thismeans that a uniform change in interest rates will cause the reinvestment rateand capital value on assets to move in opposite directions so that a fund doesnot make a lossC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: GlossaryPage 9Ine coverA calculation made for lee loanissued by panies. The ine cover isnber of times that theit of the pany(before interest payable andmcovers the interest on then(including the interest on prior ranking loans)Index-linked gilta bond issued by the British Government for which the interest payments andthe final redemption proceeds are linked to movements in the RPlIndex-linked securitya security whose redemption value and /or coupon payments are adjusted toreflect inflationIndex trackingAn index tracking fund (or an " index fund" ) is an investment fund with thespecific objective of tracking a particular index. The fund manager can eithhold all the stocks in the index in the appropriate proportions(known as"fullreplication")or use some mathematical model to choose a smaller sample ostocks which will perform as closely as possible to the index.Inflation risk premiumThe difference between the yield on a fixed ine bond and the sum of theguaranteed real yield and the expected inflation rate on a similar index-linkedbond. It is required as pensation for the uncertainty in the real return on thebond by investors with index-linked liabilities. Under the inflation risk premiumtheory the yield curve will tend to slope upwards because investors need ahigher yield to pensate them for holding longer dated stocks which are morevulnerable to inflation risk than shorter dated stocksInterna/ rate of returnThe discount rate at which the Net present value of a series of cashflows is zeroIntroductionA method of obtaining a listing for an unquoted pany which already has alarge number of investors owning its shares. No new capital is raised by thismeans. It can also happen when a share is listed on a different stock exchangeor when a merger of two existing panies occurs and a new holding panyis formedThe Actuarial Education CompanyIFE: 2009 ExaminationsPage 10CT2-19: GlossaryInvestment trustInvestment trusts are public panies whose function is to manage shares andinvestments. They have a capital structure in the same way as other publicpanies and can raise both loan and equity capital. Most have quoted sharesallowing small investors to gain exposure to the portfolio held by the investmenttrustJunk bonda bond which does not meet the usual requirements of ine cover and capitalcover for institutional investorsLeaseholdA lease is an agreement which allows one of the parties(the leaseholder)the useof a specified portion of a building for a specified period in return for somepaymentLeverageThe US term for gearing.Linked-interna/ rate of returnThis return is produced by calculating the internal (ie money-weighted) rates ofreturn for successive short periods and pounding them to give an annualrate of return If cashflows in or out of the fund are not very large and/or the rateof return does not vary much between cashflows, the linked internal rate ofreturn provides a reasonable approximation to the time-weighted rate of returnThe shorter the period chosen the closer it bees to the time-weighted rate ofreturnLiquidity preferenceThe liquidity preference theory is based on the generally accepted belief thatinvestors prefer liquid assets to illiquid ones. Investors require a greater returnto encourage them to mit funds for a longer period. Long-dated stocks areless liquid than short-dated stocks, so yields should be higher for long-datedstocksC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: GlossaryListingAn endorsement from market authorities that securities and their issuers meetspecified criteria(the Listing Rules). A necessary prerequisite for the securitiesto be traded on the marketLocal authority billsShort-dated debt securities issued by UK local authorities. The investmentcharacteristics are similar to Treasury Bills but yields are slightly higher due tothe lower marketability and marginally higher risk of defaultA long position in an asset means having an economic exposure to the asset. Infutures and forward dealing the long party is the one who has contracted to takedelivery of the asset in the future. (Compare shortMarginThe collateral deposit required by a clearing house to minimise the risk of defaultby the counterpartiesMarket capitalisationThe total value at market prices of the securities at issue for a pany, or astock market, or a sector of a stock market.Market riskMarket risk is the risk relating to changes in the value of a portfolio due tomovements in the market value of the assets heldMarking to marketThe practice of revaluing an instrument to reflect the current values of therelevant market variablesMatchingArranging assets and liabilities so that the cashflows generated by the assetscan be expected to meet the liability payouts, either because the assets generateine of the right amount at the right time or because the market values of theassets are linked to the market values of the liabilities appropriatelyThe Actuarial Education CompanyIFE: 2009 ExaminationsPage 12Mortgage debentureA mortgage debenture is a long-term corporatesecurity normally securedby a fixed charge on specified propertiesranks ahead of ordinarydebentures offering the highest degree of security among corporate bonds.Net asset value per shareThe book value of the shareholders'interests in a pany, usually excludingintangibles such as goodwill divided by the number of shares in issue.Nomina valueThis term refers to an amount of stock. It is the amount specified on the stockcertificate. Dealings in bonds are carried out in amounts of nominalOffer for saleA method of issuing shares of a previously unquoted pany. The issuinghouse, often an investment bank or specialised department of a stockbroker orclearing bank, underwrites the whole issue of the shares at a fixed price andoffers them on to the public at a slightly higher priceAn offer for sale may be made by tender a minimum price is set and the publicis invited to subscribe at this or a higher price. All shares are then issued at amon price- the strike price which just satisfies the number of sharesoffer. Any subscriber offering below the strike price will not receive any sharesOffer for subscriptionA method of issuing shares of a previously unquoted pany. the shares inthe pany are offered directly to the public. There is no underwriting. Thismethod could be used in conjunction with a tender offer instead of a fixed priceOffer priceThe price at which a market maker is prepared to sell a particular securityOpen ended investment pany(OEIC)An investment vehicle very similar to an investment trust but with the openended characteristics of a unit trustC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: GlossaryOperational gearingCompanies with high fixed costs and low marginal costs are said to have highoperational"gearing. A small change in sales gives a big change in profits forsuch panies.Operational riskOperational risk is the risk of loss due to fraud or mismanagement within thefund management organisation itself.OptionThe right to buy or sell an asset.Option premiumThe price paid for an optionOrdinary sharea share in the equity capital of a pany. Ordinary shareholders have the rightto receive all distributable profits of the pany after debt holders andpreference shareholders have been paid. they also have the right to attend andvote at general meetings of the panyOver the counter(OTC)optionPrivately negotiated derivative contracts offered by dealers directly to end-users(See Traded optionsPartly paid sharesShares may be issued on a " partly paid" basis which means that theshareholders pay only part of the cost of the share initially and pay the rest later(perhaps by instalments). This was mon with some privatisation issueswhere one of the aims was to secure many private shareholdersPar valueThe par value of a share is its nominal value. New shares cannot be issued atbelow the par value. They may be issued on a"partly paid "basis or a" fullypaid" basis (see Partly paid shares). A share premium may be payable inaddition and, if so, this share premium will be payable in full at the outset, even ifthe shares are issued on a"partly paid"basis.The Actuarial Education CompanyIFE: 2009 ExaminationsPage 14CT2-19: GlossaryPar yield curveA plot of coupon value on the y-axis against term to redemption on the x-axisFor each term, the coupon that would be required for a fixed-interest bond of thaterm to be issued at par is plottedPayback periodThe time period it takes for an investment to generate sufficient incremental cashto recover its initial incremental capital outlay in fullPayout ratioDividends divided by earnings per share. The inverse of dividend cover.PlacingA new issue method where shares are placed with institutional clients of theissuing house rather than being offered to the public. Costs are low, as nounderwriting is needed. Also known as selective marketingPreference shareA particular class of shares which generally rank ahead of ordinary sharesPreference shareholders are normally entitled to a specified rate of dividend andunlike ordinary shareholders, are not entitled to residual profits. Although partof a pany,'s share capital, from an investment perspective preference sharesare much more like fixed-interest bondsPrice earnings ratioThe ratio of a share' s price to its net earningsPER- ordinary share priceearnings per shareThe earnings per share used can be historic or prospective.PrivatisationThe sale of state assets or businesses, often to reduce government debtC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: GlossaryPut optionThe right, but not the obligation, to sell a specified asset at a specified price atspecified times.(Compare with call optionPuttable bonda bond where the holder has the right to sell it back to the issuer at certainpredetermined times for a predetermined price.(Compare callable bond.Real yieldThe yield on an investment after inflation has been allowed for. oftenapproximated as the difference between the yield realised and the rate ofinflation over the corresponding periodRedemptionThe return to an investor of the capital value of a bond or other security.Redemption may take place on a fixed date or on one of a series of specifieddates. The bond may include an option for the borrower to choose the date orfor the lender to choose. The capital amount repaid may be fixed or index-linkedRedemption yieldThe gross redemption yield (the word gross is often omitted), or yield tomaturity is the rate of return at which the discounted value of all futurepayments of interest and capital is equal to the "dirty "price of the bond. the netredemption yield allows for taxation of the amounts received by the investorRetail price inflationThe measurement of price changes at the retail(consumer) level.Return on capital employed(ROCE)Profit before interest and tax divided by capital employed, expressed as apercentage. An indicator of a pany s efficiency in generating profit from itsasset baseThe Actuarial Education CompanyIFE: 2009 ExaminationsPage 16CT2-19: GlossaryRights issueA rights issue is where a pany issues further shares, at a given price, toexisting shareholders in proportion to their existing shareholdings. Forexample, a 1-for-5 rights issue allows each shareholder to buy one new share foreach five currently held the purpose is for the issuing pany to raise moreRisk discount rateThe rate of interest used to discount anticipated cashflows from capital projectsin Net Present Value calculationsRisk premiumThe additional return required by investors in order to pensate foranticipated risksRunning yieldThe annual ine on an investment divided by its current market valueImportant examples are the flat yield on gilts, the gross dividend yield onequities and the rental yield on propertyScrip issueA scrip issue (sometimes called a capitalisation or bonus issue) is a furtherissue of new shares to existing equity shareholders. They receive free a numberof shares in proportion to their holdingsSenior debtDebt that ranks ahead of all other classes(subordinated debt) for repaymentShare buybacksRepurchase, by a pany, of its own shares in the market. Usually a tax-efficient means of returning capital to shareholdersShare splitIn a share split existing shares are split into two shares of half the originalnominal value. No new money is raised and no reserves are capitalisedC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: GlossaryShortA short position in an asset means having a negative economic exposure to theasset. In futures and forward dealing the short party is the one who hascontracted to deliver the asset in the future .(Compare longSpecific riskThe risk of holding a share which is unique to the industry or pany and canbe eliminated by having a suitably diversified portfolio of shares of differingtypes of panies. This is sometimes also referred to as alpha, unsystematicor residual riskSplit capital investment trustAn investment trust where the ordinary share capital consists of ine sharesand capital shares. Holders of ine shares receive all or most of thedistributed ine while holders of capital shares receive little or no ine butreceive the residual value of the assets after ine shares have been redeemedat a fixed value when the trust is wound upSpot interest rateThe n year spot interest rate is the geometrical average of the interest rates thatare expected to apply over the next n years. It is the redemption yield on an nyear zero-coupon bond. (see zero-coupon yield curve.Stamp dutyThe tax paid by the purchaser on the transfer of various types of asset, includingUK sharesSubordinated debtDebt that ranks behind another class (senior debt for repayment.SwapA contract between two parties under which they agree to exchange a series ofpayments according to a pre-arranged formula.The Actuarial Education CompanyIFE: 2009 ExaminationsPage 18CT2-19: GlossarySystematic riskThe risk of the individual share relative to the overall market which cannot beeliminated by diversification. It is measured by the beta factor a share with abeta greater than 1 is said to be aggressive, ie the price of the share is expectedto do better than the market when prices rise. Conversely, a share with a betaless than 1 is a defensive stock, ie its price will be expected to fall by less thanthe market when prices fallTraded optionsOption contracts with standardised features actively traded on organisedexchanges. See over the counter options.Treasury billA government bill. Usually issued with a term of 91 or 182 daysUnderwritingThe provision of some form of guarantee. In investment, underwriting is wherean institution gives a guarantee to a pany issuing new shares or bonds thatit will buy any remaining shares or bonds that are not bought by other investorsUnit trustAn open ended investment vehicle whereby investors can buy units"in anunderlying pool of assets from the trust manager. If there is demand for units,the managers can create more units for sale to investors. If there areredemptions (sales by investors), the managers will buy in units offered to them.Unit trusts are trusts in the legal senseUnsecured loan stockA form of long-term corporate debt which is not secured on the borrowersassetsWarrantAn option issued by a pany. the holder has the right to purchase shares ata specified price at specified times in the futureWeighted average cost of capitaThe aggregate return required by the providers of debt and equity capitalallowing for the effects of tax and the risks borne by the capital providersC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: GlossaryWithholding taxTax deducted from dividends in investment which are paid to non- residentYield curvea plot of yield against term to redemption. Usually the yield plotted is the grossredemption yield on coupon-paying bonds but other yields can be used. ( Seepar yield curve, zero-coupon yield curveZero-coupon bonda bond where the sole return is the payment of the nominal value on maturityZero-coupon yield curvea plot of redemption yields against term to redemption for (usually hypothetical)zero-coupon bondsThe Actuarial Education CompanyIFE: 2009 ExaminationsCT2-19: GlossaryQuestion 19.1Distinguish between(1) an American option and a European option(ii) a bill of exchange and mercial paper(iii) specific risk and systematic risk(iv) a call option and a put option(v) credit risk and market risk(vi) financial gearing and operational gearing(vii) dividend cover and dividend yield(viii fixed charge and floating charge(ix) a forward and a future(x) an ordinary share and a preference share(x1) an offer for sale and an offer for subscription(xii) a rights issue and a scrip issueC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: Glossary2 Some concluding thoughtsHaving actively studied the 19 chapters of Subject Ct2, you should now have a goodunderstanding of the key principles of financeIn Part 1 of the course, we studied the ways in which panies can set up and raiseinance. In Parts 2 and 3 of the course we studied the construction and analysis ofpany accounts. In Part 4 of the course we studied the financing decision in moredetail and also the investment decisiona There is a lot of bookwork to learn for this exam and you will be tested on yourknowledge and understanding of key terms and concepts. Beyond that, you will beequired to apply the principles you have learned in a practical contextAs a key part of your revision, remember to refer to the Syllabus Objectives in theStudy guideThe Actuarial Education CompanyIFE: 2009 ExaminationsPage 22CT2-19: GlossaryEnd of part 4You have now pleted Part 4 of the Subject CT2 NotesReviewBefore looking at the Question and Answer Bank we remend that you brieflyreview the key areas of Part 4, or maybe re-read the summaries at the end of Chapters15 to 18Question and Answer BankYou should now be able to answer the questions in Part 4 of the Question and AnswerBank. We remend that you work through several of these questions now and savethe remainder for use as part of your revision. When your revision is progressing quitewell, we remend that you attempt Part 5 of the Question and Answer Bank. Thiscontains a cross-section of questions from throughout the course.AssignmentsOn pleting this part, you should be able to attempt the questions in Assignment X4C lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: GlossaryChapter 19 SolutionsSolution 19.1(i) an American option and a European optionAn American option can be exercised on any date before its expiry whereas a Europeanoption can only be exercised at expiry(ii) a bill of exchange and mercial paperBoth are bearer documents that are issued at a discount and redeemed at para bill of exchange is a two-name form of short-term borrowing(since the billguaranteed by an investment bank) whereas mercial paper is a single-nameform of short-term borrowingCommercial paper can only be issued by large coompanies(iii) specific risk and systematic riskThe specific risk of holding a share is the risk that is unique to the industry orpany(such as the risk of staff dissatisfaction and disruption) whereassystematic risk is the risk of being exposed to the market(such as the risk ofinflation or high/low economic growthSpecific risk can be eliminated by having a suitably diversified portfolio ofshares of differing types of panies but systematic risk cannot be eliminatedby diversification(iv) a call option and a put optionA call option is the right, but not the obligation, to buy a specified asset on a set date inthe future for a specified price whereas a put option is the right, but not the obligation,to sell a specified asset at a specified price at specified times(v) credit risk and market riskCredit risk is the risk that the counterparty to an agreement will be unable or unwillingto make the payments required under the agreement. Market risk is the risk relating tochanges in the value of a portfolio due to movements in the market value of the assetsheldThe Actuarial Education CompanyIFE: 2009 ExaminationsPage 24CT2-19: Glossary(vi) dividend cover and dividend yieldDividend cover is the number of times that the dividend payments are covered byearnings for the relevant period. Dividend yield is the dividend expressed as apercentage of the share price.(vii) financial gearing and operational gearingFinancial gearing is a measurement of the relative proportions of debt and equityfinance that a pany uses. A highly geared pany has a high proportion of debtfinance and therefore finds that a relatively small change in operating profit has arelatively large impact on earnings for shareholdersOperational gearing is a measurement of the relative proportions of fixed and variablecosts incurred by a pany. a highly geared pany has a high proportion of fixedcost and therefore finds that a relatively small change in sales causes a relatively largechange in operating profit(vili) fixed charge and floating chargefloating charge occurs where all assets are assigned as security for a deb ebt whereas aA fixed charge occurs where specific assets are assigned as security for a de(ix) a forward and a futureBoth are agreements to buy or sell an asset for a fixed price at some fixed date in thefuture. However, whereas forwards are tailor-made and traded over the counter(otc)futures are standardised and traded on a recognised exchangeC lFE: 2009 Examinationshe Actuarial Education CompanyCT2-19: Glossary(x) an ordinary share and a preference sharePreference shareholders are normally entitled to a specified rate of dividend(rather like debt holders receive a specified coupon rate) whereas ordinaryshareholders have no specified rate of dividendPreference shareholders rank above ordinary shareholders (but below debtholders)Ordinary shareholders have the right to receive all distributable profits of thepany after debt holders and preference shareholders have been paidOrdinary shareholders have the right to attend and vote at general meetings ofthe panyAlthough preference shares are part of a pany's share capital, from aninvestment perspective, they are much more like fixed-interest bonds(x1) an offer for sale and an offer for subscriptionBoth are possible methods of issuing shares of a previously unquoted panyBoth an offer for sale and an offer for subscription could be made at a fixedprice or by tenderIn an offer for sale, an issuing house organises the whole issue of the shares tothe public whereas in an offer for subscription the pany itself offers theshares directly to the publicIn an offer for sale, the issuing house underwrites the share issue but with anoffer for subscription there is no underwriting(xii) a rights issue and a scrip issueA rights issue is a further issue of shares, at a given price, to existingshareholders in proportion to their existing shareholdings. A scrip issue is aexisting shareholdingsA rights issue therefore raises new funds for the pany whereas the scripissue does notA rights issue will increase share capital and reserves, whereas a scrip issue willraise share capital but reduce reserves to leave the total of share capital andreserves constantThe Actuarial Education CompanyIFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1-QuestionsPart 1-QuestionsIntroductionQuestion& Answer Bank cover the polit into five parts. The first four parts of theThis Question Answer Bank isfour parts of the course and the last part contains aset of exam-style questions covering the whole courseEach part contapamultiple-choice questionsloThis is just like the Subject CT2 exam, except that the proportions of each type ofquestion in each part may differ, exaIn the Subject CT2 exam, the proportions will bemultiple-choice questions(2 marks each)-20short questions(between 4 and 10 marks each)-40%long questions(20 marks each)-40%For each part of the Question Answer Bank, the questions may require knowledgefrom earlier parts of the course.We strongly remend that you use these questions to practise the techniquesnecessary to pass the exam. Do not use them as a set of material to learn but attemptthe questions for yourself under strict exam-style conditions, before looking at thesolutions providedThe distinction represents the difference between active studying and passive studyingGiven that the examiners will be aiming to set questions to make you think(and inip va g so they will be devising questions that you haven't seen before)it is much betterdyou practise the skills that they will be testingIt may also be useful to you if you group a number of the questions together to attemptunder timed conditions. Ideally three hours would be set aside but anything from onehour(ie 35 marks )upwards will help your time managementThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 2CT2: Q&A Bank Part 1-QuestionsMultiple-choice questionsQuestion 1.1Which of the following items might appear in a panys Memorandum ofAssociationI a statement that it is a public limited panythe total nominal value of its authorised share capitalIl the pany's audited accountsI and llABCDb II and IIIIII onl[2]Question 1.2A limited liability partnership differs from a limited pany in thata it is not a separate legal entityb there must be one member with unlimited liabilitit has no memorandum or articles of associationd action cannot be taken against individual members for fraud and negligence. [2Question 1.3In the case of a public panythe ordinary shares must be quoted on the Stock ExchangeII ordinary shareholders have one vote per share heldIl the issued share capital must not be less than f50.000b II and Ill only are correctc I and ll only are correctIii only is correct@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1-QuestionsPage 3Question 1.4Which of the following statements concerning Eurobonds is false?a Eurobonds are often issued outside the country of the currency of issueb Eurobonds are often issued outside the country of the borrowerC Eurosterlingd Eurobonds are only issued in europe[2]Question 1.5Consider the following definitionThe lender's security is a specified asset which the borrower cannot dispose of(without the lender's permission). The lender can repossess upon default or appoint areceiver to intercept ine(eg rent)This is a definition ofABwarrantc fixed-charge debentured floating-charge debentureQuestion 1.6Investors in the ordinary shahave their liability limited tea the market price of the sharesb the fully paid value of the shac the nominal value of their holdingd the capital value of their holding, less any dividends dueThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 1-QuestionsQuestion 1.7Which of the following is often used by panies that are suffering from cashflowproblems arising from late-paying customers?Ahire purchasb bills of exchangec invoice discountingtrade credit[2]Question 1.8a pany has issued the followingsubordinated loan stockIl floating-rate notesIv floating-charge debenturesWhich of the following is the order of priority in the event of a winding-up of theAI,I,Ⅲ,ⅣBIL IV.IL. IIV.II.LIIDT,I,II,Ⅱ[2]Question 1.9An investor may buy a call option if she expectsABthe value of the underlying security to increasethe value of the underlying security to fallc interest rates toa stock market crash@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1-QuestionsPage 5Question 1. 10Which of the following is correct?a Interest payments are always greater than dividend paymentsB Interest is paid out of pre-tax profit and dividends are paid out of post-tax profitc Interest is paid on debentures and dividends are paid on unsecured loan stock.d Interest is taxable but dividends are not[2]Question 1.11Which of the following could result in a pany obtaining a stock exchange listing?II an offer for subscriptionIIIplacingI and IIABCDII and IllyIl only[2]Question 1.12An arrangement whereby a pany's shares obtain a quotation on the London StockExchange, and most of the shares that are made available are bought by a small number ofinstitutional investors is known asa a placingBCDan offer for subscriptionan introductionan offer for sale[2]The Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 1-QuestionsQuestion 1.13Margin”is:a the cost of buying an optionb the cost of buying a futurec a"deposit" paid to the writer of a future or option by the purchaser.d a deposit" paid to the clearing house by the buyer and seller of a future and thewriter of an option[2Question 1.14Dividends on preference sharesal requirement on theII are counted as franked investment ineIll are paid at the discretion of the directorsAI and llBII and mCDⅢonly[2]Question 1.15Which of the following is paid last if a pany is wound upA EurobondsB mortgage debenturesC floating-charge debenturesd preference shares[2]@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1-QuestionsPage7Question 1.16A highly risk-averse investor should NOT invest in ordinary shares becausea ordinary shares offer a low expected return relative to other securitiesb ordinary shareholders have the last entitlement in the event of a winding-up ofc they offer a low initial yieldd shareholders have pre-emptive rightsQuestion 1.17Under a floating chargehe pany may, in the usual course of business, realise assets whicharesubject to the chaa default by the pany will make the charge crystallise into a fixed chargeIll specific assets are available to meet investors'claims if the pany defaults oninterest or capital paymentsABII and ll[2]Question 1.18Taxable profits for a pany areAadjusted pre-tax accounting profitsb trading profits less capital allowancesC unadjusted ine(after expenses)plus capital gainsnone of the aboveThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 1-QuestionsQuestion 1.19Which of the following situations is least likely to give rise to agency costs?a a car manufacturing business, which employs managers to carry out day-to-dayB an oil refining business in which the government takes a great interestwage negotiations in which managers have more information than unionsd a retailing business, which has one owner-managerQuestion 1.20The main significance of the par value of an ordinary share is thatit is the minimum price at which shares can be issued by the pany angea it is the minimum price at which shares can be traded on the Stock ExchBCit is the price at which the shares will be redeemedd at prices above the par value a pany must have a scrip iQuestion 1.21Which of the following will not dilute the value of the equity in a business?warrantsABCDEurobondsconvertible loan stockexecutive stock optionsQuestion 1.22Which of the following strategies would NoT help a pany to reduce its exposure torising interest rates?a the negotiation of an interest rateb the purchase of a put option on an interest rate futurec the purchase of a bond futured the sale of an interest rate future[2]@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1-QuestionsPage 9Questions 1. 23 and 1. 24 relate to Company XYZ. The balance sheet of XYZ prior tothe rights issue is given below(all figures in f000s)Non-current assets400 Share capitalCurrent assets100 ( Ordinary shares of f7)Other reservesRetained earnings330500500The of the panys shares is currently f7 per shareQuestion 1.23If the pany has a 1-for-3 rights issue at f5, the expected ex-rights price of the sharesill beA£7.00Bf6.50C£5.50f5.00Question 1.24Following the rights issue, the panys other reserves will beAf330,000Bf250,000C£210,000D£50.000Question 1.25E100 nominal of a convertible bond gives the right to purchase 70 ordinary shares. Themarket prices of the convertible bond and ordinary shares are t120 and 90 pencerespectively. The conversion premium per share isa lIpBCD171DThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 10CT2: Q&A Bank Part 1-QuestionsShort questionsQuestion 1.26Describe the role of the financial managerQuestion 1.27Explain how businesses are subject to the disciplines of the capital markets[4]Question 1.28Give three sources of personal ine that are tax-free in the UK. What otheradjustments to total ine are made in order to arrive at taxable ine?Question 1.29Outline the system of capital gains tax as it applies to individuals in the UKQuestion 1.30Explain the differences between a sole trader, a partnership, a pany and a limitedliability partnershipQuestion 1.31Describe mercial paper. How does it differ from a bill of exchange?Question 1.32Ordinary shares are the main way in which UK panies are financed. Describe themain characteristics of ordinary shares and explain their popularity amongst both issuersand investors@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1-QuestionsQuestion 1.33Loan stock can be issued in many forms. What are the generic characteristics of loanstock?Question 1.34Describe the investment characteristics of convertible bondsQuestion 1.35An investor purchases a convertible loan stock convertible to one ordinary share at anytime up to 3 1 December 2012. List the possible courses of action open to the investor,and state circumstances in which each might be appropriateQuestion 1.36Outline the nature of interest rate swapsQuestion 1.37Explain how currency swaps differ from interest rate swaps[2]Question 1.38Compare and contrast futures and opticons[6]Question 1.39Explain the role of the underwriters of a share issueThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 1Long questionQuestion 1. 40You are a director of Piron plc, a large manufacturing pany based in the UK. Thepany produces electronic products for the world market and has branches in Europeand Asia. It is financed by a mixture of equity (ordinary and preference shares)anddebt(debentures and unsecured loan stock) finance. The pany now wishes toexpand its range of products and needs further funds for investment. As a director, youwill have to contribute to the discussion of the various financial options open to thepany.(1) One of the options being considered is a rights issue. Consider the advantagesand disadvantages of a rights issue for Piron plc(i) The Finance Director has suggested that the pany could issue EurobondsConsider the advantages and disadvantages of Eurobonds for Piron plc(iii) What other financial options are available for Piron plc?(iv) What factors will you consider when making your decision?[Total 20]@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1- SolutionsPart 1-SolutionsSolution 1.1Answer=ASolution 1.2A limited liability partnership is similar to a limited pany in that it is a separate legalentity, all its members benefit from limited liability and action can be taken againstindividual members for fraud and negligence. However, it does not have to produce aMemorandum or articles of association[2]Solution 1.3Answer=BBeing a public pany is a requirement for obtaining a quotation, but having aquotation is not a requirement for being a public panySolution 1. 4Answer= DThe term"Euro"is misleading(although the oldest, and still the main, markets are inEurope). The other statements are all correctSolution 1.5Answer= CDebentures can be either fixed-charge(or mortgage) debentures or floating-chargedebentures. Fixed-charge debentures are secured against a particular assetThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 2CT2: Q&A Bank Part 1-SolutionsSolution 1.6Shareholders' liability is limited to the fully paid-up value of their sharesSolution 17Answer=CInvoice discounting is another name for recourse factoring. This provides earlypayment of a percentage of the value of the invoices by a factor. The supplier retainscontact with the customers and when the customers eventually pay their bills, the loan isrepaid to the factor, with interestSolution 1.8Answer=CSolution 1.9answer=Aa call option gives the buyer the right to buy the underlying security at a set price thiswill be worth doing if the market price on the expiry date is higher than the exerciseprice. If interest rates rise, we might expect the value of shares to fall, so it would notbe worth buying a call option. (It might be worth buying a put option, though. [21Solution 1.10nswerInterest is paid on loan stock, whereas dividends are paid on equity. Interest could begreater than, equal to or less than dividend payments(though the overall return to equitymust be greater than the return to debt because equity is riskier for the investor). Interestpayments are treated as an expense for the pany and are therefore paid out of pre-taxprofit. Dividends are paid out of post-tax profit. Both interest and dividends are taxablethough in some countries, eg the UK, governments give at least some credit to therecipient for the tax that has already been paid by the pany@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1- SolutionsPage 3Solution 1.11Both ii and iii are used for obtaining listings[2]Solution 1.12All four are methods of obtaining a listing. A subscription and offer for sale are bothoffers made to the public (directly by the pany itself, or via an issuing houserespectively). An introduction does not make any shares availableSolution 1.13Answer= DThe margin exists to protect the clearing house against credit lossSolution 1.14Answer= BPreference dividends can be passed in certain circumstances, and they are not a legalrequirement[2Solution 1.15always paid before preferenc[2]|FE:2009EPage 4CT2: Q&A Bank Part 1-SolutionsSolution 1.16A is false, and C and D are wrong because these should not prevent a risk-averseinvestor from investing in ordinary sharesSolution 1.17nsweIII is the description of a fixed chargeSolution 1.18DThe accounting profits will differ from the taxable profits. Capital allowances are notthe only difference between accounting profits and taxable profits. C deals withaccounting profits againSolution 1.19Answer= DAgency costs arise when costs are incurred in the monitoring and influencing of othersWhen the owner is the manager there is no conflict of interestSolution 1.20Answer= BA is the market price. C is wrong because shares are not redeemed. d is false becausepanies do not have to have scrip issues@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1- SolutionsPage 5Solution 1.21Answer=BEurobonds do not have any effect on the number of shares issued. The other three couldall cause an increase in the number of shares and therefore a dilution of the value of theequity in the businessSolution 1.22Answer=CThe pany could swap a floating interest rate for a fixed interest rate to protect itfrom rising interest ratesIt could sell an interest rate future. If interest rates rise, the price of the interest ratefuture falls and thus a profit could be made on the future to offset the rise in interestrates. If interest rates fell, a loss would be made on the future but the pany wouldbenefit from the falling interest rates on its loanBy buying a put option on an interest rate future, it is buying the option to sell. It willexercise this right if interest rates riseIt would not buy a bond future. If interest rates rise, the price of the bond future willfall. It would make a loss on the future as well as suffering from higher interest rates. [2Solution 1.23Answer= BThe ex-rights price will be given by(3×7)+(1×5)3+1)[2The Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 1-SolutionsSolution 1.24The pany will issue 40, 000 new shares in a 1 for 3 rights issue( there are 120, 000shares to start with)The amount that will be transferred to the other reserves will be(the number of shares issued)x(the amount above the par value)40.000×£4=£160.000This will be added to the t50, 000 that exists already in this accountSolution 1.25Answer=AThe conversion premium is the extra amount that an investor pays for a share by buyingit as a convertible, pared with the cost of buying the share directly120In this case. the calculation-0.90=81pSolution 1.26The financial manager is the link between the firms operations and the financialmarkets. The firm needs to invest in capital equipment in order to carry out its businessoperations. To acquire such assets, the pany must raise finance from the financialmarkets[]Therefore the financial manager must make two main decisionsWhat real assets should the firm invest in? (This is the investment or capitalbudgeting decision.2. How should the cash for the investment be raised? (This is the financingdecision.The investment decision is plex, important and risky. There are often alternativeinvestment projects, each with uncertain returns over an uncertain lifespan. A wrongdecision could have very serious consequences for the firms fortunes[1@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1- SolutionsPage7The financial manger must get together with many interested parties, such as projectmanagers, production managers, marketing managers, tax experts and legal experts inorder to understand the full implications of the investment decision. The financialmanager should apply impartiality and realism to the investment decisionIn order to make appropriate financing decisions, the financial manager should have aclear understanding of the options available and the way in which the capital marketswork[1[Total 5]Solution 1.27Capital markets are continuously expressing their view of the performance of aparticular pany through the valuations of a firm's shares and bonds. The price ofthe pany's share is the market's perception of the particular firms current andexpected future performance[If managers are not using the assets of the business effectively, the market will soonknow this and its poor perception of the pany will be revealed in a lower share[]One consequence of a falling share price may be a take-over bid as the firm bees abargain for a corporate acquirer. Another consequence might be redundancy for themanager.So, by providing continuous assessment of the firms performance, the capital marketsstimulate efficiency and provide incentives to business managers to improve theirperformance[Total 4The Actuarial Education CompanyC lFE: 2009 Examinations8CT2: Q&A Bank Part 1-SolutionsSolution 1.28Three sources of ine that are tax-free in the uK aremost gambling profitsine from Isa3. most social security benefitsOther adjustments that have to be made to total ine to arrive at taxable ine are:the addition of fringe benefits such as cheap mortgagesthe deduction of tax-free expenditure such as contributions to an approvedpension scheme and charitable giftsthe deduction of appropriate allowances, eg personal allowance, age allowanceSolution 1.29A capital gain is the gain made when an asset is sold for more than it costCapital gains on some assets may be exempt. For example, in the UK, private motorcars and a main private residence are free from capital gains taxThe sale price can be reduced by any expenses associated with the sale. The purchasecost can be increased by any costs associated with the purchase and any expendituremade to enhance the value of the asset during the period the asset was held[Individualsually given an annual allowance. Any taxable gain above this is taxedat18%[1Total 4Solution 1.30Ownershipa sole trader is an organisation owned by one persona partnership is owned by two or more people.A pany is owned by its shareholdersA LLP is owned by its members@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1- SolutionsPage 9LiabilityA sole trader has unlimited liabilityPartners have unlimited liability. Individual partners are jointly and severally liable forthe debts of the partnershipShareholders of a pany have limited liabilityMembers of a llp have limited liabiliLegal identitya sole trader does not have a legal identity distinct from its ownersa partnership does not have a legal identity distinct from its ownersA pany is a legal entity distinct from its ownersA LLP is a legal entity distinct from its owners[2]Documentationa sole trader needs no documentationa partnership needs no documentation, though a Partnership Agreement is advisableA pany must have two formal legal documents(the Memorandum and articles ofAssociation) and be registered at Companies HouseA LLP is advised to have a Partnership Agreement. The LLP must be registered atCompanies HouseDisclosure and taxA sole trader prepares accounts for the tax authorities. He or she pays ine taxa partnership prepares accounts for the tax authorities. Partners pay ine taxA pany must publish its accounts. It pays corporation taxA LLP is subject to financial disclosure. Partners pay ine tax[2][Total 10The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 10CT2: Q&A Bank Part 1-SolutionsSolution 1.31Commercial paper isa short-term promissory noteissued at a discount and redeemed at para bearer documentnegotiable(ie tradeable)issued by large panies who have to meet certain minimum requirements, forexample, be listed on the London Stock Exchangesingle-name paper, ie the name of the pany that owes the money. [ Maximum 4]a bills of exchange differs in that it isissued by any panytwo-name paper, ie the name of the pany that owes the money and the nameof the bank or issuing house that is guaranteeing payment[Total 6Solution 1.32Ordinary shares are issued by panies at par or nominal value. There is no set datefor redemptionOrdinary shareholders are owners of the pany. They have certain rightsthe right to the residual profits of panies(by way of dividends)the right to the residual assets of the pany following a winding-uphe right to votecertain other rights(to receive the annual accounts, to speak at general meetingsetc)[Maximum 4Ordinary shares are attractive to issuers becausethey are the lowest ranking form of finance issued by paniesdividends are not a legal obligation of the pany and are paid only at thediscretion of the directorsrunning yields are usually low because of the expected capital gainthey are attractive to investors(see below)@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1- SolutionsPage 11Ordinary shares are attractive to investors becausethey should provide a high rate of return. Dividends and capital values areexpected to grow over time. Profits are likely to grow due to inflation andtherefore shares are likely to offer protection from inflation with a high real rateof return. Due to their residual nature, the level of dividends and the capitvalue will be more volatile than most investment forms. As a consequence ofthis risk, the return can be expected to be highthey are often highly marketable, though it varies greatly from the shares of alarge quoted pany to a small family run pany whose shares are notquoted. Issues of ordinary shares tend to be large and of a standard type. Aide range of industries may be invested in. Buying and selling of ordinaryshares by investors takes place relatively frequentlyIMaximum 4[Total 12]Solution 1.33Bondholders are creditors of the pany. They have no voting rights. Their rights areet out in a loan agreement. In most cases a trustee is appointed to look after theinterests of the bondholders. The Trust Deed sets out the obligations of the pany tothe bondholders- for example, bondholders may acquire voting rights in certaincircumstancesa bond gives the holder the right to an annual coupon(usually paid in two instalments)and the redemption of the nominal value after a certain fixed amount of timeThe coupon is usually a fixed proportion of the nominal value. For example, a 5%debenture will pay t5 interest per annum for each f100 of stockThe market price of the bond varies with the demand for and the supply of the bondOne of the main influences on the price of a bond is the interest rate being offeredelsewhere. If interest rates rise, the price of bonds tends to fall[Most stocks are issued close to par and thus there is rarely much in the way of capital(although coupons and terms do vary). Consequently they usuallyprovide a higher running yield than equities. However, the overall return on a fixedinterest security is likely to be slightly less than from an equity issued by the sameborrower due to the greater security of fixed interest investments[]Marketability of corporate bonds tends to be lower than the marketability of theequivalent equity and lower than Government bonds, which are extremely marketable[]The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 12CT2: Q&A Bank Part 1-SolutionsSolution 1.34Convertible bonds are issues of loan capital, which give the holder the option to convertinto equity. The dates and terms of conversion will be fixed at the outsetThe investment characteristics of convertible bonds may be similar tontionalbonds or to ordinary shares or a bination of both[lIt depends on whether or not conversion is likely. If conversion is almost certain, aconvertible is effectively the same as the underlying share with a different inestream in the period before conversion. If conversion is unlikely, the convertible is versimilar to a normal fixed-interest bondIn all cases the option to convert will have some positive value. This value will behighest when there is most uncertainty as to whether conversion will occur or not. [I.This uncertainty/option value can be measured by the conversion premium. This is theprice paid for an ordinary share by buying a convertible (ie the effective conversionprice per share) less the market price of an ordinary share. The"effective conversionprice per share"is given byprice of convertible =number of shares it converts into[2[Total 71Solution 1.35Convert nowCould be appropriate if the value to the investor(after tax)of the dividend is bigger thanthe loan stock coupon[1Convert laterIf interest ine is bigger, the investor could wait until the dividend grows to exceedit. He or she might even wait a bit longer than that if dividends were thought to bevolatileConvert at last possible dateThe investor might do this if the interest ine remained higher thathroughout the whole life of the loan stock. This would be the correct course of actionif the share price was higher than the remaining value of the loan stock@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1- SolutionsSellThe investor might do this if he or she wanted the money and the market value of theconvertible loan stock was bigger than the market value of the shares it converted to(which it should be). The sale proceeds might then be reinvested in the shares[]Hold to redemptionDo this if none of the situations described above apply[]Solution 1.36Interest rate swaps are deals arranged with banks as the main market makers in an"overthe-counter," market. This means that the arrangements are made on an individual basithere is no set format or contract for interest rate swaps[1In a swap the two parties agree to swap a series of payments with each other. They areagreements to exchange streams of cashflow. In an interest rate swap, there is noexchange of capital amounts[]In the most mon form of interest rate swap one party agrees to pay to the other aregular series of fixed interest payments on the nominal capital for a certain term. Inexchange, the second party agrees to pay a series of variable interest payments on thenominal capital based on the level of a short-term interest rate[l[Total 3]Solution 1.37Currency swaps are agreements to exchange a series of interest payments and a capitalsum in one currency for a series of interest payments and a capital sum in another [1This contrasts with interest rate swaps, where there is no exchange of capital sums. [1]The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 14CT2: Q&A Bank Part 1-SolutionsSolution 1.38Both futures and options are derivative instruments: their value depends on theperformance of an underlying assetBoth are traded on liFfe, through the london clearing house[]Both are standardised. tradeable contractsA future gives the obligation to trade in a specified quantity of a specified asset at aspecified price on a specified date[]An option gives the right but not the obligation to trade in a specified quantity of aspecified asset at a specified price on or before a specified dateThe buyer and the seller of a future must both deposit margin with the clearing houseWith an options contract, only the seller(writer) has to deposit margin[1[Total 6Solution 1.39Underwriting is a form of insurance against the risk of an unsuccessful issueThe pany sells all the shares at an agreed price to the issuing house. The issuinghouse, acting as lead underwriter, agrees to take up any shares that are not subscribedfor by the publicThe issuing house will not usually want to retain the entire risk, therefore the leadunderwriter will often arrange for sub-underwriters(usually big financial institutions egife offices) to bee involved. However, the lead underwriter is still responsible if asub-underwriter defaultsIn return for underwriting the share issue, the pany will pay the issuing house a feeAlternatively, in the case of an offer for sale the fee can be included in the differencebetween the price at which the shares are sold to the issuing house and the price atwhich they are sold to the publicIf the share issue is fully subscribed, the underwriters make a profit equal to the fee lesstheir expenses. If the issue is undersubscribed, the underwriters are left with the surplusshares. They will sell these in the market at a later dateotal@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1- SolutionsSolution 1. 40a rights issueThe pany offers further shares to existing shareholders in proportion to their existingholding at a discount to the current share priceAdvantagesThe pany receives new capital to finance its expansion plansEquity finance is less risky for the pany than debt finance.Dividends are paid at the discretion of the directors. There is greater opportunityto plough back profits into the businessThe shares should be attractive to the shareholders since the business has goodprospects for the future. They should be able to be sold at only a slight discount tothe current share priceIMaximum 3]DisadvantagesThe pany will have to check that the total share capital after its proposed newissue does not exceed its authorised share capitalThe share price will fall. How far it falls depends on the extent of the discountthe number of new shares issued, and the market view of the rights issueThe pany will consider the cost of the issue, including underwriting costs(ifthey choose to have the issue underwritten)There may be adverse shareholder reaction to the issue. Some shareholders maynot be able to afford to buy new shares at the time of the issue and will bedisappointed to see their control of the pany dilutedMaximum 3][Total 6The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 16CT2: Q&A Bank Part 1- Solutions(ii) EurobondsEurobonds are unsecured loans offered to international investorsAdvantagesEurobond issues attract investors from around the worldEurobond issues do not e under the tax or legal jurisdiction of any countryThis lack of regulation keeps the cost of borrowing downThe cost of borrowing may be lower than equivalent borrowing in the UK or aforeign countryEurobonds may be denominated in almost any currency. This would suitPiron plc, which does business in Europe and asiaEurobonds are a convenient way of borrowing foreign currency without enteringoverseas financial markets[Maximum 4DisadvantagesThe minimum sum to be raised by Eurobonds is $75 million. Piron plc may notwant to raise as much as thisIssues are arranged by a syndicate of investment banks. Piron plc will have tonegotiate the arrangements for the issue and the fee to be paid to the arrangingbankstal 6](iii) Other optionsThe pany could considerdebenturesunsecured loan stocksubordinated debtpreference sharesconvertible loan stockconvertible preference shares@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 1- Solutions(iv)ctors to considerBefore making its decision, Piron plc should consider the followinghe cost of raising the finance the pany should consider the initial issuecost, plus the return that will have to be paid to the investorsthe tax position. Interest on debt finance is tax deductible, whereas dividendpayments are not.the risk to the pany. Interest on debt has to be paid, whereas dividends arepaid at the discretion of the directors. If Piron plc were to hit a bad patch,eg political unrest in a country that it deals with, high interest payments could bevery difficult to paythe effect on control. Debt holders have no vote, but shareholders do. Piron plprobably has many small shareholders at present so this is not likely to be ofgreat concern to themflexibility of finance. Share capital is usually irredeemable(though sharebuybacks are possible) whereas debt is redeemable and can be issued at varioustermsassets held. If the pany has few tangible assets, it is difficult to raise debtfinance. This is not likely to be a problem for Piron plc since it ismanufacturing pany with a substantial and increasing amountequipmentMaximum 5hese factors will be considered in more detail in Part 4 of the courseThe Actuarial Education CompanyC lFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2-QuestionsPart 2-QuestionsMultiple-choice questionsQuestion 2. 1The term"current asset as used in pany reports and accounts describes those asseta falling due after less than one monthb falling due after less than three monthsc falling due after less than one yeard not intended for continuing use in the panys activities[2]Question 2.2The term "inventories as used in pany reports and accounts describesb work-in-progress and finished goods for resale onlyC raw materials, work-in-progress and finished goods for resale onlyD raw materials and consumables, work-in-progress and finished goodsQuestion 2.3Which of the following is treated as a credit item in the trial balance?ABelectricity charges[2]|FE:2009EationsPage 2CT2: Q&A Bank Part 2-QuestionsQuestion 2. 4Which of the following is responsible for developing, issuing and withdrawing accountingstandards?AInternational Accounting Standards boardBAuditing Practices boardC International Financial Reporting StandardsDepartment of Trade and Indu[2Question 2.5Inventories are valued at the lower of cost or net realisable value. This is an applicationof which accounting concept?a cost conceptBCprudenealisation conceptQuestion 2.6What are non-current assets?a tangible assets with an expected life of more than one yearb tangible assets which are not held for sale in the normal course of businessc assets which are not held for sale in the normal course of businessDmachines. factories and other immobile assets which are not intended for resale@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2-QuestionsPage 3Question 2.7Which of the following is true?Depreciation adjustments are attempts to reflect the value of non-current assetsin the balance sheetDepreciation adjustments ensure that funds are available for the eventuareplacement of the assetIII Depreciation is a measure of the wearing out or consumption of a non-currentasset over timea I and Il only are correctBII and iii only are correctc I only is corred IIi only is correctQuestion 2.8The following items may appear in a panys balance sheet under the headingtangible assetsI development expenditureIIinvestmentsa I and II onlyBII and ill only are correctCI only is correctDIⅢ only is correct[2]The Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 2-QuestionsQuestion 2.9An increase in the value of a non-current asset recognised in the revaluation reservewouldncrease the equity of the panyII make the balance sheet look strongerIII increase the profit of the panya I and ll only are correctB II and Ill only are correctCI only is correctii only is correctQuestion 2.10The following figures were taken from a pany's account2007Operating profit£20,000£25,000Depreciationf5,0005,000Working capitalf8.000£4,00(inventories trade receivables -trade payables)What is the panys cash inflow from operating activities for the year ended 2007?A£19,000Bf21,000C£25000£29.000[2]@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2-QuestionsPage 5Question 2.11Which of the following statements most accurately describes the main purpose of theexternal audit of a limited pany?a To review the pany's accounting systems and related internal controlsB To assist the directors to prepare the panys annual financial statementsC To express an opinion on the truth and fairness of the panys annualfinancial statementd To prevent and detect fraud within the pany.[2]Question 2. 12ace plc has authorised share capital of f750,000. On 1 July 1998 it issued its first400,000 fl ordinary shares for t1.50 each. On 30 March 2007, the pany decided toraise more capital through making a one-for-five rights issue. All the existinshareholders took up their rights. What should appear as the nominal value of ace plc'sshare capital in its accounts for the year ended 30 June 2007?A£600.000B480,000C£720.000£900.000[2]Question 2.13The following items might be found in a cashflow statement under the headingcashflows from investing activitiesissue of ordinary share capitalII receipts from sales of non-current asset investmentsIl payments to acquire tangible non-current assetsa I and ii only are correctBII and iii only are correctConly is coIII only is correct[2]The Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 2-QuestionsQuestion 2. 14Which of the following is NOT required as part of a listed pany's annual report andaccounts?a directors'reportBine statement and balance sheetauditors'reportd chairman's statementQuestion 2.15The XYZ pany bought a new machine for t80, 000. The assumed useful life of themachine is 10 years. At the end of this time, its estimated scrap value is f5, 000. Thepany charges depreciation on this machine using the reducing balance methoThe machine is shown in XYZ's balance sheet after two years at a value ofA£22.005B£45,948Cf60.000£65,000Question 2.16Which of the following is NOT a current liability?Atrade receivablesBtrade payablesd provision for tax( to be paid in six weeks)[2]Question 2.17Expenses are recognised when they are incurred. It is not necessary to wait until thebills are paid”statement refers to thea realisation conceptBc going concern conceptmoney measurement concept[2]@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2-QuestionsPage 7Short questionsQuestion 2.18(i) List the elements of a set of financial statements that are required under thCompanies Act and state the one overriding requirement of the financialstatements[3](ii) A pany's accounts should ply with various accounting conceptsOutline the cost concept and the going concern concept[Total 5]Question 2.19Describe the different opinions that a panys auditors may give on the pany'sfinancial statements and the circumstances in which each might be appropriate[7Question 2.20The published accounts of a United Kingdom manufacturing pany for a particularyear showed the following(a) operating profit of t5,000,000(b) 10% depreciation on assets valued at f1.5 million(c) interest of 5% on a loan stock with a nominal value of f2 million(d) entertainment expenses of t300,000( d) net investment ine of f180,000 from dividends on ordinary shares of otherUnited Kingdom paniesAssuming that1. the tax authority calculated that the capital allowances for the year came tof400,000the tax authority judged that only half of the panys entertainment expensesthe first 3/4 of the accounting year fell into a financial year in which corporation taxas 3 1%, and the remainder into a financial year in which corporation tax wascalculate the pany's total corporation tax bill for that accounting yearThe Actuarial Education CompanyC lFE: 2009 Examinations8CT2: Q&A Bank Part 2-QuestionsQuestion 2. 21State whether each of the following statements is true or false, giving reasons for youranswers(i) The ine statement shows the cash generated by a pany over the last year[3(ii) It is possible to calculate the market value of the shareholders'interest in apany from data shown in its balance sheet(ii a change in accounting policy that reduces a pany's depreciation charge bfl million will usually increase the post-tax profits attributable to ordinaryshareholders by fl million[3](iv) a provision is a potential liability which had not materialised as a liability by thedate of the balance sheet, eg payments that might bee due in respect ofguarantees given to banks, or goods sold under warrantyQuestion 2.22Define the following accounting terms(1) authorised capital(ii) depreciation[2](iii) revaluation reserve(iv) non-current assets@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2-QuestionsPage 9Question 2.23Explain the role of each of the following items in a pany's report and accounts( i) the balance sheet[2](ii) the ine statement(iii) the auditors'report[2]The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 10CT2: Q&A Bank Part 2-QuestionsLong questionsQuestion 2.24At 3 1 December 2006 the balance sheet of a pany was as follows£ASSEtSNon-current assets300,000less depreciation(90,000210,000Current assetsInventories62,500Trade receivables10,650Cash1282585975Total assets295975EQUITY AND LIABILITIESOrdinary share capital100.000Reserves39,350Total equity139,350Non-current liabilities12% Debenture loan150.000Current liabilitiesTrade payables6.625Total liabilities156,625Total equity and liabilities295975@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2-QuestionsDuring 2007 the following items appeared in the pany's accounting recordssales190,750increase in inventories9,250decrease in trade receivables1,7rent of factory30,000costs of raw materials45.000salaries and wages55.000miscellaneous expenses2.750purchase of non-current assets 40,000The non-current assets are being depreciated on a straight line basis over a period of tenyears including the year of purchase. During 2007 interest was paid on the debenturecorporation tax is 30%, but the pany did not pay its tax during 200/ e the rate ofstock but no dividends were paid on the ordinary share capital. AssPrrep(i) the ine statement for 2007(ii) the balance sheet as at 31 December 2007[Total 14The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 12CT2: Q&A Bank Part 2-QuestionsQuestion 2.25At 31 July 2006 the balance sheet of BOLd PLC was as followsASSETSNon-current assetsFreehold land and buildings2.000Other non-current assets700Current assets400Trade receivables300CashTotal assetsEQUITY AND LIABILITIESOrdinary shares of 20p1,20Retained earningTotal equityNon-current liabilities12% Mortgage1.000Current liabilitiesTrade payables190T390Total liabilities1390Total equity and liabilities3.520@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2-QuestionsThe following information is available for the year to 31 July 2007(E00Os)decrease in cashincrease in inventories50decrease in trade receivables130decrease in trade payableswages. rent etccost of raw materialscost of building extension to freehold buildings200depreciation of freehold land and buildingsother depreciationtax paid110Payment of dividend declared for year ending31July2006100Assuming a corporation tax rate of 30%, and a proposedpayout ratio(dividends/earnings )of 40%, prepare(i) the ine statement for the year ending 31 July 2007(ii the balance sheet as at 3 1 July 2007[8(ii) the statement of changes in equity for the year ending 31 July 2007.[3][Total 16]The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 14CT2: Q&A Bank Part 2-QuestionsQuestion 2. 26Shown below is the balance sheet dated 3 1 December 2006 for Bodgit Fixit,amanufacturing firm making tools and DIY equipmentASSETSNon-current assetsFactory675,000Machinery125000800.000Current assetsInventories85.000Trade receivables25.000Cash40.000150.000Total assets950.000EQUITY AND LIABILITIESIssued ordinary shares of 50p250,000Other reservesShare premium account 100,000Revaluation reserve800.000Retained earnings87000Total equity517000Non-current liabilitiesConvertible loan stock 2010200.00010% Debentures 2016150.000350.000Current liabilitiesTrade payables30.000B:ank loan30.0008,000Tax payable1500083,000Total liabilities433.000Total equity and liabilities950.000@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2-QuestionsDuring 2007, the following occurred555000increase in inventories17,000purchases of raw materials112,00085,000electricity costs91,000advertising delivery costs59.000h447,000increase in trade payables5000dividends paid12.000tax paid13.000You are also given the following information(a) The pany repaid its bank loan on 5 January 2007(b) The factory was originally purchased in December 1995. It was beingdepreciated on a straight line basis over 20 years, with an assumed residual valueof zero. In January 2006 it was revalued from its then current value ofE670,000. The machinery was purchased in 2006 for a price of f150, 000. It isbeing depreciated over a period of six years(c) The revaluation reserve arises from the revaluation of the factory only(d) The first conversion date for the 8% CULS was 15 December 2007. f100,000nominal was converted. The conversion terms were 2 shares for every t5nominal of convertible stock. Interest was paid before conversion took place(e) The directors were concerned about the level of trade receivables at the end of2006, and decided to set up a provision for bad debts equal to 10% of the tradereceivables outstanding at the end of the accounting yearAssuming a tax rate of 30% and a proposed and approved(by the shareholders) payoutratio of 30%, draw up the ine statement for 2007 and the balance sheet dated31 December 2007 in a form suitable for publicationThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 16CT2: Q&A Bank Part 2-QuestionsQuestion 2. 27The following information has been extracted from the bookkeeping records ofPerso plcTrial balance as at 31 December 2007f000£000BankTrade payables187Trade receivablesLand and buildings-cost1,300Land and buildings-depreciation195450Plant and machinery-cost800Plant and machinery -depreciation140Retained earnings at 3 1 December 2006215Raw materials purchasedAdvertisingDirectors remunerationSales1,175700Other reserves180Inventories at 3 1 December 2006Salaries -factory staffSalaries-administratior(1) Depreciation is to be charged on the following basesBuildings-on a straight line basis, assuming a residual value of f100, 000 on31 December 2010. The book value of the buildings on 3 1 december 2006 was£555,000Plant and machinery -20% of reducing balance@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2-Questions(2) The directors have proposed to pay a total dividend of f17, 000 forear. buthis haby the shareholders. No dividendrelation to the 2006 accounting year. There was no change in the issued shareapital during 2007(3) The corporation tax charge has been estimated at t12, 000 for the year. No taxwas payable in respect of the 2006 accounting year.(4) Inventories at 3 1 December 2007 were f8,000(5) In the balance sheet at 31 December 2006, trade payables were f131,000, tradereceivables were 199.000. cash at bank was t6.000 and loans were f750.000(1) Prepare Perso plc's ine statement for the year ended 3 1 December 2007 andits balance sheet as at that date. These should be in a formpublication insofar as this is possible from the information provided suitable for(ii) Prepare Perso plc's cashflow statement for the year ended 31 December 2007.[Total 201The Actuarial Education CompanyC lFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2- SolutionsPart 2-SolutionsSolution 2.1Answer= DOddly enough not defined strictly as falling due in less than one year!Solution 2.2Answer= DSolution 23Answer= CThe credits on the trial balance include revenue items from the ine statement andequity and liabilities from the balance sheet. a bank overdraft is a current liability. [2]Solution 2. 4Answer= ASolution 2.5Answer=CAccording to the prudence concept, assets should not be overestimated. If there is someuncertainty about the value of the inventories(eg easter eggs after Easter! )and it is feltthat the sale value is lower than the cost value then the lower(net realisable) valueshould be used in the balance sheet[2]The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 2CT2: Q&A Bank Part 2-SolutionsSolution 2.6Answer= CNon-current assets may be tangible or intangible. They may also be mobile(eg a lorry)[2]Solution 27Answer= DDepreciating an asset is not an attempt to estimate its value in the sense that it can besold at this price. It will not ensure that funds are available to buy a replacementDepreciation represents the wearing out or the using up of the asset over a period oftimeSolution 28Answer=ANon-current assets are shown under one of three headingstangible non -current assetsintangible non-current assets(eg goodwill)InvestmentsDevelopment expenditure can be shown on the balance sheet as an intangible asset, justthe purchase cost of machines is shown as a tangible asset. In both casesdepreciation, rather than the purchase cost, would then be shown in the inestatement over a number of years[2]Solution 29Answer=AThe value of the non-current asset would increase and there would be an increase in therevaluation reserve. The equity of the pany is the shareholders'fund, ie capital andreserves, so the equity would increase too. The profit would not increase in this caserofit would increase if the increase in the value of the asset were recognised in theine statement@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2- SolutionsPage 3Solution 2 10The cash inflow from operating activities is found as follows£20,000plus depreciationf5.000less increase in working capital£4,000£21.000[2]Solution 2.11The wording of a typical auditors'report isIn our opinion, the financial statements give a true and fair view, in accordance withIFRSs as adopted by the European Union, of the state of the group's and the parentand of the group's and the parent panys profitlloss/for the year then ended, and the financial statements and the part of the directorsRemuneration Report to be audited have been properly prepared in accordance with theCompanies Act 1985 and Article 4 of the lAS Regulation. The information given in theDirectors'Report is consistent with the financial statementsSolution 212Answer= BBefore the rights issue, the nominal value of the pany's share capital is£l×400.000=400.000After a l-for-5 rights issue, the nominal amount of share capital will be400,000×==480,000[2]The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 4CT2: Q&A Bank Part 2-SolutionsSolution 2.13BI would be under the heading"cashflows from financing activities". In a cashflowstatement, ""cashflows from investing activities"refers to purchases or sales of noncurrent assets, including investments that are non-current, ie investments that thepany intends to hold for more than a yearSolution 2 14Answer= DIn practice D often acpanies the report and accounts, but it isrequirementSolution 215Answer= Be first need to calculate the depreciation rate, r80.0004-)=5,000V80=0.7578524214After 2 years, the value of the machine in the balance sheet is80,000(0.757858)[2]Solution 216Answer= ATrade receivables are a current asset of the business[2]@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2- SolutionsPage 5Solution 2.17Solution 218(i Requirements of the Companies ActCompanies must producea balance sheetan ine statementdetailed disclosures which are normally presented as notes to the accountsa directors’ reportan auditors'reportThe overriding requirement is that the financial statements must give a true and fairVIewfor each of the six points, total 3() Accounting conceptsaccording to the cost concept, non-current assets should be valued at cost lessdepreciation[]According to the going concern concept, accounts should be prepared on theassumption that the business will continue indefinitely in its present form[Total 2Solution 2.19An unqualified opinion is a statement that, in the opinion of the auditorsthe financial statements and the part of the Directors'Remuneration Report tobe audited have been properly prepared in accordance with the paniesAct 1985 and Article 4 of the IAS Regulationthe financial statements give a true and fair view, in accordance with IFRSs asadopted by the eu, of the state of the group's and the panys affairs; and v2the information given in the Directors' Report is consistent with the financialstatementsThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 2-SolutionsThe wording of the standard report can be modified if the auditor wishes to highlight anuncertainty or is not able to express an unqualified opinion that the accounts give a trueand fair viewThere are various degrees of qualificationEmphasis of matter paragraphsIf there is a significant uncertainty, which has been disclosed in the accounts, theauditors should point this out. However, if the financial statements give a true and fairview, then the auditor would issue an unqualified opinion[1]Qualified opiniona qualified opinion might be issued where the auditor disagrees with the treatment of amatter in the financial statements or when there has been a limitation on the informationobtained by the auditor, but the auditor is still able to express an opinionDisclaimer of opiniona disclaimer of opinion may be issued when the scope of the audit is limited and as aresult the auditors cannot obtain sufficient information to give an opiniona disclaimer may be given if the auditors feel the pany has restricted the scope oftheir investigations or does not keep adequate accounting recordsAdverse opinionAn adverse opinion is issued when the auditor believes that the financial statements donot give a true and fair view and the effect is so material that a qualified opinion is notadequate to express the misleading or inplete nature of the financial statements. [1]Such an opinion may be given when the pany and the auditors disagree over theaccounting treatment of a particular, material transaction. The auditors would set outthe changes that would be required to overe the issue[Total 71@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2- SolutionsPage7Solution 2.20Operating profit5,000,000dd back depreciation150.000add back half of entertainment expenses 150,000deduct capital allowances400.000deduct interest paid100.000Adjusted profit4,800,000[I mark for each adjustment, total 4]In the UK, panies pay no more tax on the dividend ine receivedTherefore, the panys corporation tax liability×0.31+×0.30)×4,800,00£1,476,000[2]ITotal 71Solution 2.21(1 Statement(The ine statement shows the cash generated by a pany over the last yearFALSEThe ine statement is drawn up using the realisation and accruals concepts. Cashamounts are not necessarily shown. For example, depreciation"and"change in valueof inventories'"are shown but do not represent actual cashflows. Other items, egsalesare shown at a value that may differ from the actual cash amounts paid/receivedThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 2-Solutions(ii) Statement (ii)It is possible to calculate the market value of the shareholders'interest in a panyfrom data shown in its balance sheetFALSEThe balance sheet shows accounting values onlyThese relate to accountingconventions rather than market values. Share capital is shown in the accounts as thenumber of shares multiplied by the nominal value of a share. The market valuecalculated by multiplying the number of shares in issue by the market price per share. [2(111 Statement (iii)a change in accounting policy that reduces a panys depreciation charge byEl million will usually increase the post-tax profits attributable to ordinary shareholdersby£ I millionTRUE[This will increase operating profit and hence pre-tax profit by the amount of the reduceddepreciation. The tax charge will not change since tax is based on capital allowancesrather than on the depreciation shown in the accounts. Shareholders' earnings willtherefore also increase by the amount of the reduced depreciation(iv) Statement(iv)a provision is a potential liability which had not materialised as a liability by the dateof the balance sheet, eg payments that might bee due in respect of guarantees givento banks, or goods sold under warrantyFALSE[1The question is discussing a"contingent liability, which would be included as a note tothe accounts. A provision is eitheran amount written off to provide for depreciationan amount retained for a liability or loss that is either likely to occur, or certainto occur but uncertain as to the amount or timing[Total 8@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2- SolutionsPage 9Solution 2.22( 1) Authorised CapitalThis is the maximum amount of share capital which the panys directors can issue(or mit themselves to the possibility of issuing through conversion rights) includinall the pany ' s shares currently in issue[]It is the nominal amount of share capital of the pany written into the memorandumof associationThe amount can be increased by the passing of a resolution by the shareholders(ii) DepreciationDepreciation is a measure of the wearing out or using up of a non-current asset overlme[]It is a notional charge in the ine statement to allow for the cost of using the assetover the accounting periodIn the balance sheet it reduces the value of the non-current assets and the notionalcharge on the ine statement reduces the retained earnings and the tax due(iii) Revaluation reserveeserves, to reflect any revaluations of the panys land and buildings capital andThe revaluation reserve is held as part of the pany's equity, ie the[]If, for example, the pany's land was purchased in 1990 at t100,000 but is revaluedin 2007 at f500,000, then the process of revaluation increases the non-current assets ofthe pany by f400,000 and increases the revaluation reserve by t400, 000(iv) Non-current assetsNon-current assets are assets that are held for a long time by the business and are usedby the business to produce goods and services for sale. They are not sold in the normalcourse of business[]There are three types of non-current assetsTangible non-current assets, eg machinery, vehicles, buildings and land2. Intangible non-current assets, eg patents, goodwill, trademark3. Investments, eg shares in other panies, government bonds[The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 10CT2: Q&A Bank Part 2-SolutionsSolution 223(i) The balance sheetThe balance sheet in the report and accounts is a summary or snapshot of the assetsliabilities and capital of a pany at the end of the accounting period[1]The assets of the business are the things that are owned by the business. Finance forthese assets is provided bythe owners of the business(capital), andthose who have lent money to the business either directly, eg loan stock, orindirectly, eg trade payables (liabilities)[](ii) The ine statementThe ine statement shown in the report and accounts is a summary of the trading of apany over the last accounting period, which is usually a year[]The revenue received from trading is pared with the costs associated with earningthis revenue. The difference is the profit(or loss)(iii) Auditors'reportThe role of the auditors'report is to ment owhether, in the opinion of the auditors, the financial statements and the part ofthe Directors Remuneration Report to be audited have been properly preparedwhether, in the opinion of the auditors, the accounts give a true and fair viewwhether the information given in the Directors' Report is consistent with thefinancial statement[1There are four possible modifications to the standard reportemphasis of matter paragraphs2. qualified opinion3. disclaimer of opinionadverse opinion[1@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2- SolutionsPage 11Solution 2.24CommentFor this and subsequent accounts questions, start with the total mark, deduct 2 marksfor the first mistake and I mark for each subsequent mistake, down to a minimum of0Where possible follow through mistakes to see whether or not you are using correctprinciples, and only deduct further marks for further mistakes(i) Ine statement for 2007Revenue190,750Cost of salesraw materials45.000lesscrease in inventories(9,250)salaries/wage55,000depreciation34.000Gross profi66,000Expensesrent of factory(30,000)miscellaneous expenses(2,750)Operating profit33,250Finance costs18,000)Net profit before tax15,250Tax at 30%4575Profit for the year attributable6to equity holdersno dividends were paid to ordinary shareholders in the yearNotes1. (300,000 cost of old assets 40,000 purchase)x 10%12%×£150,000Nb Wages and salaries are assumed to vary directly with output and therefore areincluded in the cost of sales. You could argue that they are an overhead inwhich case you would include them as an expense[6 for ine statement and notesThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 12CT2: Q&A Bank Part 2-Solutions(ii) Balance Sheet for 31 December 2007ASSETSNon-current assets340.000less Depreciation(124.000Current assetsInventories71,750Trade receivables8,95016.77597,475Total assets313,475EQUITY AND LIABILITIESOrdinary share capital100,000R02Total equity150,025Non-current liabilities12% Debenture loan150,000Current liabilities887Tax provision4.57513,450Total liabilities163,450Total equity and liabilities313,4751. f300,000 carried forward, plus f40,000 purchased this year2. f90, 000 from last years balance sheet plus f34, 000 from this year's inestatement3. E62, 500 from last year's balance sheet plus E9, 250 increase in inventoriesf10.650 carried forward from last year, less this years decrease of f1. 700@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2- SolutioCalculated as followscash at start of year12,825revenue plus decrease in trade receivables190.750+1.700less costs, net of increase in trade payables(30,000+45,000+55,000+2,750-2,25less purchase of non-current assets(40,000)less interest cost(18,000cash at end of year16,7756. f39, 350 carried forward from last year's balance sheet plus f10, 675 from thyear's profitE6, 625 carried forward from last year, plus this year's increase of f2, 250[8 for balance sheet and notesCash reconciliation is not asked for, so Note 5 could be omitted. Instead, cash could befound as the"balancing item", assuming everything else has been calculated correctly.This is a risky exam strategy!The Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 2- SolutionSolution 225(i) Ine statement for BOLD PLC for 2007increase in inventordepreciatedofit530Expense210rating pr20)(1,000×0.12)Net profit before taxpr200Tax@ 30%(60)ar attributable to equityholdersa dividend totalling t100, 000 was paid to ordinary shareholders during the year inrespect of the year ending 31 July 20065 for the ine statement@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2- Solutions(ii) Balance sheet for BOLD PLC as at 31July 2007ASSETSNon-current assetsFreehold land and buildings2.168Other non-current assets6072,775Current assetsnventories450Trade receivables170Total assets3.420EQUITY AND LIABILITIESOrdinary shares of 20p,20Retained earningsTotal equity2,170Non-current liabilities12% Mortgage1,00Current liabilitiesTrade payables100Total liabilitiesTotal equity and liabilities3.420notes2.000+200-32930-100(dividend paid)+140200+60-1105. A dividend of E56,000, ie 40%x E140,000, is proposed in respect of the yearending 3 1 July 2007[8 for the balance sheet and notesThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 16CT2: Q&A Bank Part 2-Solutions(iii) Statement of changes in equity for BOLD PLC for 2007Attributable to equity holders£OOOsOther Retained TotalcablreservesearningsequityBalance at 31 July 2006l,2009302,130Profit for 200740140Total recognised ine for 2007140140Dividends paid(100(100)Balance at 31 July 20071,2009702,170[3 marks@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2- SolutionSolution 2.26Ine statement for Bodgit Fixit for the year ending 31 December 2007Sales555.000Cost of salesraw materialsl12.000ncrease in inventories(17,000depreciation100.000(195000)Gross profit360,000Expensesstaff costs5,000electricity91,000advertising delivery costs59,000provision for doubtful debts213.300(248300)Operating profit111700Net profit before taxTax@ 30%24,210Profit for the year attributable to equity holders56,490a dividend totalling f12,000 was paid to ordinary shareholders during the yearTo calculate the depreciation on the factory, we need to find out the value of thefactory after revaluation. This will have been 670,000 plus the revaluationreserve of 80,000, ie f750,000. As there was still ten years of the factory's lifeto run, we depreciate the factory from its new value over the remaining term. Sothe depreciation charge for the factory is 10%X750,000=75, 000The depreciation charge for the machinery will be 176X 150,000=25,0002.10%×[25,000+(555000-447,000)0.08×200.000+0.1×150.000The directors propose and the shareholders have approved a total dividend oft16,947(ie 30%x f56, 490)in respect of the year ending 3 1 December 2007[8 for ine statement with notesThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 18CT2: Q&A Bank Part 2-SolutionsBalance sheet for Bodgit& Fixit at 31 December 2007ASSETSNon-current assets600,000675,000-75,000Machinery100.000125,000-25,000700.000Current assetsnventories102.00085,000+17,000Trade receivables133.00025.000+(555000-447,000Provision for bad debt(13,300)10%×133,00079.000see note 1Total assets1000.700EQUITY AND LIABILITIESIssued ordinary shares of 50p270,000see note 2Other reservesShare premium account180.000see Note 2Revaluation reserve80.0Retained earnil126.54387,000+56,490-16,947Total equity656543Non-current liabilities8% Convertible loan stock 2010100,000200.000-100.00010% Debentures 2016150.000250.000Current liabilitiesTrade payables55,00030000+25,000Dividends pa8000+16,947-12,000Tax payable26.21015.000+24,210-13.00094.157Total liabilities344157Total equity and liabilities1,000.700@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2- SolutionsCalculated as follows:cash at start of year40.000plus cash payments received447,000less costs(112,00085,000+91,000+59,000plus increase in trade payables25.000less interest cost(31,000)less repayment of bank loanless tax and dividends paid(13,000+12,000cash at end of year79.0002. The number of new shares issued as a result of the conversion was100,000×2/5=40,000As the par value of the shares is 50p, the issued share capital needs to increaseby f20.000. The share premium account increase by[12 for balance sheet with notesCash reconciliation is not asked for, so Note I could be omitted. Instead, cash could befound as the "balancing item", assuming everything else has been calculated correctlyAgain, this is a risky exam strateThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 2-SolutionsSolution 2.27(i) The ine statement and balance sheetThe ine statement for Perso plc for the year ending 31 December 2007£000Sales revenueCost of stock sold500Depreciation of buildingsDepreciation of plant and machinery132Salaries- factory staffGross profit340Administrative expensesSalaries-administration125Directors remuneration(170)Distribution costs_(30)Operating profit140Interest(65Net profit before tax75TProfit for the year attributable to equityholdersNo dividends were paid to ordinary shareholders during the yearNotesCost of stock sold=opening stock+ purchases- closing stock6+502-8=5002. Buildings depreciation= 20%(555-100)=91Plant and machinery depreciation=20%(800-140)=1323. The directors propose a total dividend of f17, 000 in respyear e31 December 2007[7 for ine statement and notes@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 2- SolutionsPage 21Balance sheet for Perso plc as at 31 December 2007ASSETSNon-current assetsLand and buildings -cost1,300Plant and machinery-cost1.542Current assetsInventoriesTrade receivables265Total assets1807EQUITY AND LIABILITIESOther reserves180Retained earningsTotal equityNon-current liabilitiesL450Current liabilitiesTrade payablesIXTotal liabilities649Total equity and liabilities18071. Total depreciation to date onbuildings=195+91=286plant and machinery=140+132=2722. Retained earnings=215+63=278[7 for balance sheet and notesThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 22CT2: Q&A Bank Part 2-Solutions(ii) The cashflow statementThe cashflow statement for Perso plc for the year ending 31 December 2007£O00Cashflows from operating activitiesCash generated from operationsInterest paidTNet cash generated from operating activities306Cashflows from investing activitiesCashflows from financing activitiesRepayment of loan capital(300)Increase in cash over the year6NotesCalculated as followOperating profit140t depreciationincrease in inventoriesincrease in trade receivables(46)increase in trade payablesCash generated from operations371[6 for cashflow statement and notes@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3-QuestionsPart 3-QuestionsMultiple-choice questionsQuestions 3. 1 to 3. 6 are based on the following figures taken from a pany's publishedreport and accountscurrent assets19,000current liabilities17.000nventories11.000inventories last year12.000long-term debt9,000revenue25,000cost of sale7.000distribution costs3.000administrative expensesnet asset value80,000Question 3. 1The capital gearing ratio isA0.112:B0.13750.1429D0.50Question 3.2The current ratio0.47B0.89D1.76The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 2CT2: Q&A Bank Part 3-QuestionsQuestion 3. 3The quick ratioABCD1.76[2Question 3. 4The stock turnover using average levels of stock over the year isABCD0.61.642.33uestion 3.5The operating profit margin isABCD50%[2]Question 3. 6The return on capital employed is10%ABCD1450%1399[2]@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3-QuestionsPage 3The next three questions are based on the following figures from the accounts of ABCLtdInventories at the beginning of the yearInventories at the end of thePurchases130Administrative expenses15PrBank overdraft12Trade payables10accruals2Question 3.7Using cost of sales in the formula, the average stock turnover period of ABC Ltd in daysAb 46 dayCd 78 dayQuestion 3.8ABC Ltds current ratA2.5:1BDThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 3-QuestionsQuestion 3. 9Assume that pany ABC Ltd has in issue 200,000 ordinary shares of 50p each. Durinthe year, it paid a dividend of 4.5p. Calculate ABC Ltds dividend cover. (Ignoretaxationa 2.5 timesBI timesC6. 7 times[2]Question 3. 10A Ltd paid 5400,000 for 200,000 shares in B Ltd. B Ltds share capital was 250,000Calculate the goodwill associated with this purchase Setl ordinary shares, and at the time of the share purchase it had reserves of f125,000A£25,000Bf100,000C£200000D£275,000Question 3.11Filton plc has shares in three panies. It has a 35% holding in Worthington Ltd andhas a right to appoint 6 of the 10 directors. It has a 55% holding in Bartley ltd and hasused its voting rights to appoint all of its directors. It has a 25% holding in Dudley Ltdand has a right to appoint 3 of the 10 directors. Which are subsidiaries of Filton plc?a Dudley Ltd, Worthington Ltd and Bartley ltdb Worthington Ltd and Bartley ltdC Bartley ltd onlyd dudley ltd only@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3-QuestionsPage 5The next three questions refer to PRP Ltd. The following details were extracted fromthe pany's 2007 accounting recordsPre-tax profi57,000T1,200Depreciation2,100Inventories held a 31. 12.0642.100Inventories held 31 12.0746,50012% Loan stock 2012(nominal amount)15,000Revenue103,250Share capital and reserves425.000Non-cI55,000Question 3. 12PRP's return on capital employed for 2007 wasA12.68%B12.95C13.36%D13.84%Question 3. 13PRPs average stock turnover period for 2007 wasB 154 daysCD 160 daysQuestion 3. 14The figure for "net cash generated from operating activities"shown in PRP's cashflowstatement wasA£51700£53.500C£56500£58.800[2]The Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 3-QuestionsQuestion 3. 15Which of the following might explain why the Pe ratio of a particular pany maystand above the average PE ratio of other panies?earnings are perceived to be riskyhistorical earnings are unusually lowIll potential earnings growth is very highAI and llb II and IIICOQuestion 3. 16Which of the following items does not occur in the revenue account of insurancepany accounts?Aearned premiumsb clinvestment ine on investments relating to shareholders'fundsDealised capital gains on investments held to cover insurance liabilities@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3-QuestionsPage7Short questionsQuestion 3. 17You will not be required to construct consolidated statements in the examination, butyou could be asked to explain how they are constructed. The first part of this questionmight be useful in helping you understand how to construct such statementsimr pany X recently bought a 100% holding in Company Y for f4 million cashImmediately prior to the acquisition the two separate balance sheets were as follow 3(all figures in t millionsCompanmy X Company YNon-current assets104Current assetTotal assetsShare capital23Non-current liabilitiesCurrent liabilitiesTotal equity andliabilities(i) Draw up the consolidated balance sheet for Company X following the acquisition(ii) Company X only managed to buy 70% of Company Y(for t2. 8 million cash)leaving 30% of Company Y in the hands of minority shareholders. Describe howminority interests are treated in a consolidated balance sheet. Explain why theyare treated in this wayQuestion 3. 18Explain what is meant by a subsidiary pany.[2]Question 3. 19State the main weaknesses of historical cost accounts in times of high inflationThe Actuarial Education CompanyC lFE: 2009 Examinations8CT2: Q&A Bank Part 3-QuestionsQuestion 3. 20Discuss the main limitations of ratio anal ysiQuestion 3. 21Company A takes over Company B. Immediately before the take-over, Company Bsbalance sheet appeared as followsCompany B£000sNon-current assets240Current assetsOrdinary share capital (10p shares)eserve250Long-term debt120The terms of the offer made to bs shareholders for every nine shares held in b were3 shares(50p market value each) in A plus90p cash plus2 f2 convertible preference shares in A(valued at par)The terms of the conversion on the f2 preference shares are 5 ordinary shares for eachf2 preference shareCalculate the goodwill which will initially appear in As consolidated accounts as aresult of the offer assuming(i) conversion does not take place[S](ii) full conversion@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3-Questions9Long questionsQuestion 3. 22The long questions on ratio analysis in the examination usually ask you to analyse a seof accounts. This question is a useful introductionFor each of the following accounting or investment ratios(i) net asset value per share(ii) profit margin(iii) current ratio(iv) return on capital employed(a) define the ratio(b) explain what the ratio might indicate[8]( c) suggest reasons why the ratio might be misleading or meaningless as farshareholders are concerned[Total 20The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 10CT2: Q&A Bank Part 3-QuestionsQuestion 3. 23Shown below is the balance sheet for 3 1 December 2006 of Kwaint Kountry Kitchens,achain of cookshop in the home countiesBalance sheet for Kwaint Kountry Kitchens for 31 December 2006ASSETSNon-current assetsLand and buildings800,000Current assetsInⅴ enter425.000Cash125,000Trade receivables28,000578.000Total assets1,378,000EQUITY AND LIABILITIESShare capital(fl par value)700.000Other reserves200,000Retained earnings225500Total equity1.125.500Non-current liabilities12% Unsecured Loan Stock 2012150,000Current liabilitiesTrade payables51,000Tax dueOverdraft25000Total liabilities252.500Total equity and liabilities1,378,000@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3-QuestionsDuring 2007, the following events occurredIn January, the pany bought shares in Kevins Kookware for a considerationof f400, 000. This was financed by the issue of f200, 000 nominal of 8%Convertible Unsecured Loan Stock 2014. and t100.000 nominal of 10%Debentures 2016. The loan stock were issued at par. The remaining f100, 000was paid for out of cashIn January, the pany also acquired the exclusive rights to sell the newMuesli Meadow"design of kitchenware, for a price of f100,000. It proposes toshow these rights as an asset in its balance sheet, and to depreciate these rightsby the straight line method over 10 yearsThe panys operating profit for 2006 was f243,000, on revenue oft1, 215,000. Revenue increased by 3% in 2007, and operating profit wast120, 000. The pany paid the interest on its loan stocks in fullThe pany's total tax charge for 2007 was t18,000. It paid tax of t32, 000during the year. The pany proposed dividends of 7p per share for the 2007trading year. The dividends it actually paid amounted to t32, 000Inventories increased by 54, 500 and trade receivables increased by f10,000Trade payables increased by f17, 000. The pany reduced its overdraft b£15.000.The panys non-current assets consist of shops and land. The land wasvalued in 2004 at f200,000 and is not subject to depreciation. The shops werepurchased in 2002 at a price of fI million and are being depreciated using thestraight line method over 10 years(1 Prepare the balance sheet for 3 1 December 2007[8](ii Draw up the pany's cashflow statement for the trading year ending on31 December 2007(iii) Comment on the panys performance during 2006 and 2007, usingappropriate ratios to support your argument. You should address the aspects ofprofitability, liquidity and efficiency[Total 24The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 12CT2: Q&A Bank Part 3-QuestionsQuestion 3. 24The following information has been extracted from the accounting records ofWitchita plcTrial balance at 30 September 2007(in E000s)Factory(cost)3200Factory(depreciation)200Inventories as at 1 October 2006Trade receivables120Trade payables150Sales revenue800Machinery(cost)570Machinery(depreciation)240chasesRent, rates and insuranceAdministration costs57Share capital2000Retained earnings at 1 October 2006Loan stock-5% 201254046014601Notes (a) Closing stock on 30 September 2007 was valued at E80,000(b) The tax charge for the year has been estimated as f25, 000c) The directors propose to pay a dividend of f24, 000charged at 1% of cost; depreciation onmachinery is charged as 20% of the reducing balance; and half of theoutstanding balance on intangible assets is written off each year(e) At the end of the year the directors had the factory professionallyrevalued. The value of the site is now estimated to be i3. 1 million@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3-Questions(1) Prepare Witchita pIc's ine statement for the year ended 30 September 2007and its balance sheet at that date. These should be in a form suitable forabdication(ii) Analyse and discuss the liquidity position of the pany and its operatingefficiency[Total 201The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 14CT2: Q&A Bank Part 3-QuestionsQuestion 3. 25You work for the finance director of a manufacturing pany, Drummer plc. Extractsfrom Drummer plc's financial statements for 2006 and 2007 are shown below. Over2007 there has been a restructuring of the distribution network and a large marketinginitiative to increase sales. The sales director has reported that the project has been agreat success overall and sales have risen by 25%() Explain whether you agree with the sales director's conclusion. Support youranswer with appropriate ratios[l6(ii Following the announcement of the 2007 financial results, the share price ofDrummer Limited is 145p. A year before, the price was 141p. The nominalvalue of the shares is 25p. Briefly analyse the markets reaction to thepanys performance.[Total 20Drummer pIne statement200720006£O00£O00Revenue45,000Cost of sales46.75037.400Gross profit9,2507.600Expenses6.2004.700Operating profit2,900Interest receivedInterest payable560Profit before taxation4932.775TaxationProfit attributable to equity holders1,745a dividend of 5486,000 was paid to ordinary shareholders during 2007 in respect of the2006 financial year.In 2007, the directors proposed and the shareholders approved a total dividend of£436.000.@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3-QuestionsDrummer plcBalance sheets3/ Dec 200731 Dec 2006£000£O00£000£000ASSETSNon-current assets30.25024.000Current assetsInventories4.250Trade receivables,3505,550Bank60011,6008.150Total assets41,85032,150EQUITY AND LIABILITIESShare capital3.0003.0004.141832Total equity27,14125832Non-current liabilitiesong-term8.0002,000Current liabilitiesBank overdraftTrade payables5,5002,999748Dividend4366.7094,318Total liabilities14,709Total equity and liabilities41,85032,150The Actuarial Education CompanyC lFE: 2009 ExaminationsAll study material produced by actEd is copyright and is soldfor the exclusive use of the purchaser. The copyright is ownedby Institute and Faculty Education Limited, a subsidiary ofthe Faculty and Institute of ActuariesYou may not hire out, lend, give out, sell, store or transmitelectronically or photocopy any part of the study materialYou must take care of your study material to ensure that it isnot used or copied by anybody elseLegal action will be taken if these terms are infringed. Inaddition, we may seek to take disciplinary action through theprofession or through your employerThese conditions remain in force after you have finished usinthe courseC lFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3- SolutionPart 3-SolutionsSolution 3. 1Answer= Adebt finance 9, 000Capital gearing(or simply gearing)0.1125equity80.000Notice that net asset value is equivalent to equity, ie share capital plus reserves. Thereare no options for the alternative definitions of gearingSolution 3. 2Answer=C[2]Solution 3. 3Solution 3. 4Answer=CAverage stock turnoveraverage stock level 11, 5001.64cost of sales7.000No options are given for the alternative definition of stock turnover ie stock/sales. [2]Solution 3. 5AlOperating promt margin operating profit_(25,000-7, 000-2, 500-3, 000)-50%revenue5,000The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 2CT2: Q&A Bank Part 3- SolutionsSolution 3. 6Return on total capital employed(roce)is defined aslet profit before tax and interestlong-term debt equityIn the absence of information on interest received. assume this is zero. therefore netprofit before tax and interest is the same as operating profit. ThusROCE(25,000-700-2,00-3,00014%89.000Solution 3.7Answer= CThe question asks for the average stock turnover period. This means that the value ofstocks should be the average of the start and end year figures(ie 25)The question also asks us to use cost of sales in the formula. The cost of sales is:opening stock purchases-closing stock= 30+130-20=140The stock turnover period in days is thereforestock×365=65dav[2]costof sales 140@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3- SolutionsPage 3Solution 3. 8Answer=Bcurrent assetscurrent ratiocurrent liabilitiesIn this case current assets consist of closing inventories, trade receivables, prepayments(ie payments made for goods that have not yet been received)and cashIn this case current liabilities (ie creditors falling due within one year consist ofoverdrafts, trade payables and accruals(expenses which have been incurred in theperiod but which will be paid for in a later period, eg gas bills)So the current ratio is20+40+3+17=3.3312+10+2Solution 3. 9Answer= CDividend coverNet profit after taxDividend distributedProfitsDecrease in inventories(10purchases(of raw materials etc)(130)administrative expenses(15)Dividend cover is therefore: 45=(200 X0.045)=5Note that this ignores items on which we have no information. For example, productionexpenses(other than purchases), distribution expenses and interest paid/receivable aswell as taxationThe Actuarial Education CompanyC lFE: 2009 ExaminationsPage 4CT2: Q&A Bank Part 3- SolutionsSolution 3. 10BGoodwill is calculated as follows400.000-200.000250.000000000[2]Solution 3.11Answer= BThe holding pany has a controlling interest in its subsidiariesSolution 3. 12erReturn on capital employed is defined asnet profit before tax and interest ornet profit before taxlong-term debt t equityTo find the figure for net profit before tax and interest we need to add the loan stockinterest back onto the pre-tax profitThe calculation is then57,000+(15,000×0.12)=13.36%425,000+15,000The other definition of return on capital employed, ie net profit before tax/equity, is notoffered as an option@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3- SolutionsPage 5Solution 3. 13Average stock turnover periodtock×36544.3×365103.25Solution 3. 14Answer= BWe want to find net cash generated from operating activities, which isless interest paididless tax paidwhere cash generated from operations isig proplus depreciationg capitalOperating profit(ie profit before interest paid)=57, 000+0.12 X 15,000=58, 800So cash generated from operating activities i=58,800+2,100-(46,500-42,100=56500and net cash generated from operating activities is56,500-1,800-1,200=53,500Since you were given pre-tax profit (ie after the deduction of interest), you could havecalculated net cash generated from operating activities as57,000+2,00-4,400-1,200=53,500The Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 3- SolutionsSolution 3. 15BTemporarily depressed earnings can give a very high historic PE ratio because earningare expected to grow rapidly from a low base. Thus Il and Ill are correct. I would leadto a low price and hence a low pe ratioSolution 3. 16Answer=CThe revenue account is concerned with normal insurance business. Investment ineon investments relating to shareholders'funds appears on the non-technical inestatement@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3- SolutionPage7Solution 3. 17(1) Consolidated balance sheetWe must first calculate the goodwill involved in the transaction. This can be calculatedby paring the value of the shares or cash paid to acquire Company Y against thebook value of the assets purchasedodwill=£4n-£3m=£lm[]We can then construct the following consolidated balance sheet(all figures in f millions)Company X consolidatedNotesNon-current15Current assetsTotal assetsShare capitaReserves3eqiNon-current liabilitiesCurrent liabilitiesTotal equity and liabilitiesThe fl million goodwill has been added to the non-current assets[]The total current assets of X and y total f9 million however f4 million ofcash has been paid in respect of the transaction, therefore the remaining currentassets would total f5 million[1The assets and liabilities of Company X and Company Y have been added,[t, after having cancelled out the internal relationship to avoid the double counting ofs investment in yThe Actuarial Education CompanyC lFE: 2009 ExaminationsCT2: Q&A Bank Part 3- Solutions(ii) Minority interestsMinority interests are shown as a separate item in a consolidated balance sheet, in theequity section, after the capital and reserves attributable to equity holdersCompany X has paid f2. 8 million cash for f2. 1 million worth of share capital andeserves of Company Y, thus paying E0. 7 million for goodwill. Minority shareholdersown 30% of the value of Company Y(30% of f3m=E0.9m). The consolidated balancesheet would look as follows:(all figures in f millionsXNon-current assets14.7Current assets.2Total assets20.9Capital and reserves attributable to equity holdersof the panyShare caplResMinority interests0.9Total equity9.9Non-current liabilitieCurrent liabilitiesTotal liabilitiesTotal equity and liabilities[2]If a holding pany has a controlling interest in a subsidiary pany, it holds apercentage of the subsidiarys shares but it controls all of its assets. Thus it would notbe appropriate to simply include the appropriate percentage of net assets(as would bethe case for an associate pany). Instead, on consolidation, all of the subsidiary'sassets are included (including goodwill)along with a separate item to identify minorityInterests@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3- SolutionsPage 9Solution 3. 18A subsidiary pany is one that is controlled by a holding panyThe controlling interest can arise in a number of wayThe holding pany could own a majority of the voting rightThe holding pany could hold under 50% of the voting shares but have theright to appoint or remove directors who have a majority of the voting rights atboard meetingsThe holding pany could have some other right to exercise a dominantinfluence over the subsidiarSolution 3. 19The main weaknesses of historical cost accounts in times of high inflation areThe cost of sales is underestimated and therefore profit is overstated. If, forexample, an item is purchased for t1o and sold for fl5 the pany will recorda profit of t5. If, however, the cost of replacing that item of stock has increasedto fl2 then the "real" profit on the transaction is only f3If depreciation is calculated using the historical cost of the assets, thedepreciation charge will be inadequate and thus again, profit will be overstated[]Interest payments will decline in real terms so a pany that pays out moreinterest than it receives will find that its profits will tend to be understated intimes of high inflatio[]Accounts figures are not parable between years. Profits and asset valuesmight increase in money terms but it is not clear how much of the increase is areal increase and how much is simply due to inflation[][Total 4]The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 10CT2: Q&A Bank Part 3- SolutionsSolution 3. 20The main limitations of ratio analysisIt diverts attention from the figures themselves. The scale of the figures is lostwhen looking at ratios. Scale is important when analysing a panyperformance. For example, a large pany can benefit from economies ofscaleRatio analysis also diverts attention from the wider picture. It is also importantto look at information in the notes to the accounts and the directors ' report togain a fuller view of the conditions in which the pany is operating and itsoverall performance[]Ratios are calculated from the figures in the financial statements. They cantherefore be affected by the accounting policies used to calculate the basicaccounting figures. If, for example, two panies use different methods for thecalculation of depreciation then any ratios based on their financial statementsmight not be parable. Similarly, if property is frequently revalued, thereturn on capital employed will be lowerThe financial statements on which the ratios are based could have beendeliberately distorted by so-called creative accounting. Management couldselect accounting policies and assumptions that tend to bias the figuresRatios alone should not be used as a basis for parison between businessesAs well as different accounting policies, panies might be exposed todifferent conditions. For example, a pany that sells mainly in the domesticmarket wmore affected by a domestic recession that one that operatesthroughout the world[]When using ratios to make parisons between businesses it is important totake into account any special conditions that occur in a particular trade. Forexample, stock turnover would be expected to be lower for an antique shop thana supermarketITotal 6@ IFE: 2009 ExaminationsThe Actuarial Education CompanyCT2: Q&A Bank Part 3- SolutionsPage 11Solution 3. 21(1) Goodwill if conversion does not take placeNumber of shares in b=60.000÷0.1=600,000Net asset value of B£60,000+£250,000£310.000Value of as offer=(1/9)×(3×0.50+0.9+2×2)×600,000£426,660GoodwillExcess of amount paid for b over value of B=£426660-£310.000£116,660[Total 5(ii) Goodwill if conversion takes placeValue of a,'s offer(19)×(3×0.50+0.9+2×5×0.50)×600000=£493,330Excess paid£493,330-£310,000=£183,330[Total 3]The Actuarial Education CompanyC lFE: 2009 ExaminationsPage 12CT2: Q&A Bank Part 3- SolutionsSolution 3. 22Net asset value per share(a) ordinary share capital+reserves -intangiblesnumber of ordinary shares(b) Gives the underlying asset backing for the share, and can be pared with theshare price(often used in takeovers. If the share price is well below NAV, thenit might suggest that there isn't much scope for share price reduction. Thismight