All CB1 Past Papers

Faculty of Actuaries Institute of Actuaries
EXAMINATION
8 April 2005 (am)
Subject CT2 Finance and Financial Reporting

Core Technical
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3. Mark allocations are shown in brackets.
4. Attempt all 20 questions. From question 11 onwards begin your answer to each
question on a separate sheet.
5. Candidates should show calculations where this is appropriate.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.
Faculty of Actuaries
CT2 A2005 Institute of Actuaries
For questions 1 10 indicate in your answer book which one of the answers A, B, C or D is
correct.
1 A business made a loss during the financial year just ended but has more cash at the
end of the year than it did at the beginning. Which of the following could be a reason
for this?
A Dividends were lower this year than last year.

B Some fixed assets were sold during the year.
C Debtors took longer to pay this year than last.
D Creditors were lower at the end of this year.
[2]
2 A company expects to have net current liabilities at the financial year end. Raising
funds by taking out a short term loan would:
A increase the current ratio
B reduce the current ratio
C have no effect on the current ratio
D either increase or decrease the current ratio depending on the balances

involved and the extra funds raised
[2]
3 Sales revenue should be recognised when goods and services have been supplied;
costs are incurred when goods and services have been received.
The accounting concept which governs the above is the:
A accruals concept
B materiality concept
C realisation concept
D dual aspect concept
[2]
4 A bond has a value of £1,000 printed on its face. Its current open market value is
£980. Analysts expect the value of the bond to rise to £985 within the next seven
days. In your personal opinion it will rise to £982. What is the nominal value of this
bond?
A £980
B £982
C £985
D £1,000
[2]
CT2 A2005 2
5 Preference shares are often thought of as being more like debt than equity. Which of
the following best explains this?
A the tax treatment of preference dividends

B the ability to buy and sell preference shares
C the fixed nature of participation in profits
D the ability to make capital gains or losses
[2]
6 A business has decided to acquire a specialised piece of machinery using a finance

lease. A bank has agreed to buy the asset on the business behalf and will lease the
asset for the whole of its useful life. When will the asset become the property of the
business?
A On delivery of the asset.

B On the first lease payment.
C Once the final lease payment has been made.
D Never.
[2]
7 A company has 500,000 £1.00 ordinary shares in issue. The current market price is
£1.80. The company will make a rights issue later today, issuing 50,000 new shares
at a price of £1.50. What is the theoretical ex-rights price of the company s shares?
A £1.50
B £1.65
C £1.77
D £1.80
[2]
8 Which of the following best describes the purpose of the depreciation charge?
A An adjustment to the balance sheet value to reflect market values.
B An adjustment to the balance sheet value to avoid overvaluing assets.
C An adjustment to the profit and loss account to reflect the use of the asset
during the year.
D An adjustment to the profit and loss account to reflect the decline in values
during the year.
[2]
CT2 A2005 3 PLEASE TURN OVER

9 Which of the following best describes the purpose of the cash flow statement?
A To show how much cash is available at the end of the accounting period.
B To explain any increase or decrease in the business s working capital.
C To establish the ability of the business to pay its liabilities.
D To explain what cash has been generated by operations, and how that cash has
been utilised.
[2]
10 An investor sold a holding of a stock with the intention of buying an identical holding
of the same stock a few weeks later at roughly the same price. What possibility best
explains the likely reason for this behaviour?
A The investor is keen to develop a relationship with a new broker.
B The investor is trying to realise a capital gain in order to utilise an annual tax
allowance that will be lost otherwise.
C The investor is trying to stimulate the market s interest in the shares by

generating trading volume.
D The investor wishes to confirm the liquidity of the stock s market.

[2]
11 Company A has invested in Company B. Explain how the directors of Company A

can determine whether Company B is a subsidiary for reporting purposes.
[5]
12 Describe how probability trees are used in capital project appraisal. [5]
13 Describe the role of the external auditor in financial reporting. [5]
14 Explain how market forces would discipline the managers of a quoted company if
they were not performing in a satisfactory manner. [5]
15 The partners in a small business are considering becoming a limited company.

Explain the difference in the taxation of a partnership and a limited company. [5]
CT2 A2005 4
16 T is starting an actuarial consultancy. He intends to borrow quite heavily in order to
fund the initial startup. A friend has suggested incorporating this business as a limited
company in order to avoid all personal risk associated with business liabilities.
Explain whether incorporation would be likely to be a cost-effective way of avoiding

personal liability for the consultancy s borrowings.
[5]
17 H is considering buying shares in a major quoted company, but is concerned by the

fact that the company has a large number of options outstanding that might dilute his
investment.
(a) Explain what is meant by dilution in this context; and
(b) Explain how it might affect H s investment.

[5]
18 The directors of Cappemm plc are concerned that their beta coefficient is high and
that this might deter potential investors.
(a) Suggest a course of action for the reduction of the company s beta; and
(b) Indicate whether reducing the beta is likely to be desirable to potential

investors.
[5]

19 You are a member of a team responsible for the evaluation of investment proposals in
a large multinational company that is quoted on a major stock exchange. The
directors of one of the company s largest subsidiaries has proposed a major
investment that would double that subsidiary s manufacturing capacity and would
enable it to export to several new markets. The proposed investment would require
the company to raise a great deal of money, either by borrowing or by the issue of
equity. The amount involved is large enough to justify either a share issue or the sale
of loan stock, but not a combination of the two.
The proposal has been backed by a detailed analysis of the cash flows that are
expected to arise from this expansion.
The company has a policy of evaluating investment opportunities on the basis of the
net present value (NPV) of estimated cash flows.
(i) (a) Identify the factors that the company may use to determine the rate at
which this proposal might be discounted; and
(b) Explain which of these factors would be most relevant to this project.
[6]
(ii) Explain how the decision to raise finance using either loan stock or equity
might affect the company s weighted average cost of capital (WACC). [8]
(iii) It has been suggested that political , or subjective, factors within companies
are often more relevant to investment decisions than objective economic
factors in deciding whether a project should proceed. Explain why this might
be so. [6]
[Total 20]
20 You have been asked to advise on the distribution of the assets formerly owned by a
recently deceased client. The client had owned all of the shares of a large but
unquoted limited company, a large house and a substantial bank balance. His will had
left everything to his two sons, to be shared equally in a manner to be agreed by
both . The sons have agreed that one will take the house and the other the company.
They have agreed a valuation for the house, but cannot agree on the value to be
attached to the shares. This valuation is important because it will affect the manner in
which the bank balance will be split.
The sons have provided you with the company s most recent financial statements.
The son who will take the house has argued that the company should be valued by
taking the profit according to the latest year s profit and loss account and multiplying
it by the price/earnings ratio of a quoted company in a similar line of business. The
son who will take the company feels that it would be more appropriate to value the
company at the net assets figure according to the balance sheet. Both sons have
provided figures based on their respective methods and these differ widely.
(i) Explain the relevance of each of the two methods proposed by the sons to the
valuation of this company. [8]
(ii) Indicate, with reasons, which method is likely to give the higher figure. [2]
CT2 A2005 6
(iii) Explain whether the information in a typical company s financial statements is
sufficiently reliable to provide the basis for an objective valuation of the
company. [5]
(iv) Explain why an unquoted company should be required to prepare financial

statements. [5]
[Total 20]
END OF PAPER
CT2 A2005 7
EXAMINATION
April 2005

Core Technical
EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with
the aim of helping candidates. The questions and comments are based around
Core Reading as the interpretation of the syllabus to which the examiners are
working. They have however given credit for any alternative approach or
interpretation which they consider to be reasonable.
M Flaherty
Chairman of the Board of Examiners
15 June 2005
Institute of Actuaries
Subject CT2 (Finance and Financial Reporting Core Technical) April 2005 Examiners Report
1 B
2 A
3 C
4 D
5 C
6 D
7 C
8 C
9 D
10 B
11 The principal test is whether Company A can control Company B.

There are some guidelines for the measurement of control in the Companies Act and
accounting standards.
This could happen if Company A has purchased more than 50% of the voting shares.
Control might also arise if Company A can appoint or remove directors to or from the
board of Company B,
particularly if it could control more than 50% of the votes at board meetings in this
way.
Company A might also be able to exercise a dominant influence over Company B,
for example by entering into a contract that gives Company A the ability to exercise
control.
12 Probability trees are used to organise complex decisions where the choices available
at any stage will be affected by decisions made at earlier stages.
For example, a company can invest in an investment opportunity. Before committing
itself it can decide whether or not to purchase a report which will cost a great deal but
will enable the company to make a more reliable assessment of the project.
A probability tree will enable management to decide whether it is better to go ahead
or abandon the project without buying the report or whether to buy the report before
making a decision.
The probability tree would involve the following steps:
mapping the possible choices, beginning from the initial project decision and
branching out to represent all the possible subsequent options
assigning estimated cashflows associated with each future possible choice
estimating the probabilities associated with each future cashflow
using standard expected value calculations, incorporating both the time value of
money and the probabilities, to assess the optimal choices in each future time
period based on the knowledge of the intervening events
working backwards from the latest decision point to the present day in order to
establish the best (e.g. highest NPV) route to follow at the outset
Page 2
One use of the probability tree would be to organise the various aspects of this
complex series of decisions that have to be made in order to reach a conclusion.
13 The role of the external auditor is to add some credibility to the financial statements
published by the company.
The auditor expresses an independent opinion on the truth and fairness of the financial
statements.
This opinion is based on both detailed testing of the bookkeeping records
and an analysis of the accounting policies that have been used to prepare the
statements.
If the auditor s reported opinion supports the figures then shareholders should have
fewer concerns about the accuracy of the figures or the basis on which they have been
prepared.
This reassurance makes the capital markets more open than they would otherwise be.
Any monitoring or covenants based on published accounts will be regarded as more

effective if the statements are supported by such an opinion.
14 The markets demand an adequate rate of return from an investment.

Essentially, stock market prices reflect both the market s projections of cash flows
from the investment
and the discount rate that should be applied to these.
The quality of management can affect both the size of expected cash flows and the
risks associated with them.
If managers are seen to under perform then the share price will fail to rise, or even
fall.
That could open the way to a takeover bid from someone who wants the opportunity
to run the company more efficiently.
The buyer would then dispose of the existing management team.
There can be more immediate market disciplines. Managers are often paid in stock or
stock options.
Their performance will have an effect on the value of the financial instruments
granted to them as part of their remuneration.
15 Companies are liable for corporation tax whereas the partners in a partnership pay
income tax on their share of the profits.
The effective tax rates for the partners post-incorporation may be higher or lower.
Companies are taxed on their income plus capital gains. Partnerships do not pay
income tax on capital gains, although individual partners may pay capital gains tax on
their share of gains.
The starting point for tax for a limited company is profit from ordinary activities
before taxation. This is then adjusted for any non-allowable expenses, depreciation is
added back and gross franked investment income is deducted.
One of the main differences in the taxation of limited companies is the treatment of
dividends. Franked investment income is dividends received plus a tax credit of 10%.
The tax credit is given to recognise that dividends are paid from post tax profits.
Page 3
The imputed tax system ensures that there is no disadvantage suffered by the
shareholders when a company distributes profit.
As directors the former partners would pay income tax on their salaries and the
company pays corporation tax on the remaining profits.
The partners would previously have paid income tax on the whole profits.
16 In theory, incorporation would limit the liability of the consultants. Lenders would
have a claim against the company s assets but not those of the individuals who own it.
This advantage could prove costly though. Lenders will perceive a higher risk.
They might respond by charging a higher rate of interest which will, eventually lead
to lower profits for the consultants.
They might also seek additional security over assets, thereby imposing some
constraints on the consultants freedom to trade.
They might even demand personal guarantees from the consultants so that they
become liable for the loans despite the incorporation.
Even if the lenders did not take action to protect themselves, limited companies are
subject to some additional regulatory requirements that have to be set against the
benefits of limited liability.
For example, limited companies are subject to some reporting and filing requirements
that partnerships are not.
This would involve paying to put trading information in the public domain, where it
might prove useful to competitors or other parties.
17 (a) The option holders have the right to buy shares at the striking price. They will
almost certainly exercise those rights if the market price exceeds the striking
price.
Buying shares at a discount to the market price will spread future profits over
more shares.
The corresponding investment made by the option holders will probably be
insufficient to compensate for the broader shareholding,
hence the value of existing shares will be diluted . Effectively, this means
that H s investment might fall in value at some future date because of the
options.
(b) The current market price of the shares will reflect the fact that these options
are outstanding.
That means that H will not actually subsidise or pay for the effect of these
options.
If the options expire unexercised then H will benefit from this discount and
will not bear any cost.
On the other hand, if the share price rises then the potential upside will be
limited to some extent by the effect of the options.
That might affect the overall risk profile of the investment.
Page 4
18 (a) The most obvious way in which to reduce beta is to diversify.

The company should move into lines of business that are as dissimilar from
existing lines as possible.
The company could even conduct a historical analysis to find businesses or
industries that tend to move in the opposite direction to Cappemm plc over
time.
(b) It is unlikely that reducing beta in this way will attract investors. Investors can
diversify for themselves.
It is unlikely that they will pay a premium for this reduction. They might also
be put off by the fact that Cappemm s management will be responsible for a
substantial investment in an industry that they know little about.
The risks associated with this will be specific risks that can be diversified
away,
but the costs of managing this company will reduce profit and that will make
the investment less attractive.
Shareholders looking to build a clearly diversified portfolio might actually be

more attracted to the company that has a clear investment strategy.
They might prefer this to an artificial diversification offered by Cappemm s
new policy.
19 (i) (a) The company might have a standard hurdle rate for all capital projects.
This might take account of the cost of the company s capital.

It might even take account of the systematic risks associated with
investing in the company as identified by the company s beta.
Essentially, the discount rate should reflect the risks associated with
the project
and also the need to generate a real rate of return from the capital that
has been invested.
(b) The most appropriate rate will be specific to the risks associated with
the project itself.
Standard rates based on the company itself are not really relevant
because each project will have its own risks and rewards.
(ii) In theory, debt is cheaper than equity because lenders take fewer risks.
In theory, borrowing will reduce WACC because of the higher proportion of
debt.
In practice, this might be slightly more complicated because borrowing will
affect the gearing levels and that will affect the risk characteristics of existing
equity.
Borrowing will increase the risk of holding shares and that could increase the
cost of equity.
At higher levels of gearing the risk attached to debt might also increase and
that could increase the cost of borrowing too.
Page 5
These additional costs will offset the savings from using the cheaper source of
finance.
Borrowing also carries a tax advantage because interest can be offset against
profit whereas dividends cannot.
The Modigliani and Miller

argument suggests that the reduction in WACC due to borrowing will be
exactly offset by overall increases in the cost of equity.
This means that there is no particular cost advantage in using debt or equity.
This argument ignores taxation, though.
(iii) The models used to evaluate investment projects require many highly
subjective decisions to be made about the parameters that are to be used in the
model.
In practice, that often means that any particular project can be justified by
adjusting estimates about the projected cash flows
and the appropriate discount rate.
Companies may have formal investment appraisal systems but their
implementation may be influenced by the political status of the individuals
or the department that is sponsoring the project.
Apart from forecasting and capital considerations, arguments can be put
forward to use more basic techniques such as payback for certain projects
or to dispense with formal appraisal altogether because the project is required
for safety or for strategic purposes.
Some projects may not be individually profitable, but may be undertaken
because they are considered to benefit the company as a whole.
Sometimes a project may be undertaken to achieve synergy or compatability
with other projects undertaken by the company.
20 (i) The valuation on the basis of profit times a notional price/earnings ratio takes
account of the future earnings potential of the company.
Arguably, the P/E ratio effectively discounts all future earnings back to their
NPV.
This approach could be influenced by the accounting policies of the
companies involved
but is otherwise theoretically sound because nothing is omitted from the
calculation.
The P/E model ignores the possibility that the deceased proprietor may have
had a substantial input into the earning capacity of the business.
His absence may reduce future profits.
It also ignores the possibility that the son who inherits the business may have
to work full-time in order to bring about the future profits and this model
would include the value of his labour along with the inherent value of the
company.
Page 6
The asset based valuation restricts the valuation to those assets that can be
measured in the financial statements.
It ignores factors such as goodwill and staff skills.
It is also highly open to influence from accounting estimates and assumptions.
The asset basis may be more appropriate if the business is to be sold as it

stands and if the new owner will have to replace the input provided by the
founder.
(ii) Given that the P/E model takes account of all of the future cash flows and
profits,
it would normally give a much higher valuation than the asset basis.
(iii) With most information gathering systems there is normally a trade-off

between reliability and cost.
Financial statements are prepared on the basis of historical costs because these
can be determined reasonably quickly and easily.
They are not necessarily the most relevant basis for most decisions, but it is
argued that they are generally prepared for stewardship purposes
and so any inaccuracy is unlikely to undermine their relevance.
Past performance is not necessarily a guide to future performance, and it is
future performance that is relevant to valuations.
The financial statements are generally prepared on the basis of highly

subjective estimates about such issues as asset lives.
These could have a significant impact on the profit figure and balance sheet
valuations, all of which could affect any company valuation.
Typically, financial statements omit balances, such as internally generated
goodwill,
which would be difficult to value in any meaningful way. That further
undermines their relevance to company valuations.
(iv) All companies confer the privilege of limited liability on their owners.
It is important that anyone dealing with the company has some protection from
the potential abuses associated with limited liability.
Reliable financial statements are one such source of protection, particularly
when combined with agreements that can be expressed in terms of accounting
numbers.
For example, a bank might grant a loan in return for an agreement that the
gearing ratio will be kept below a particular percentage.
The financial statements enable shareholders to make decisions about their

relationship with the company.
They can decide whether to support the present management or call for a
change on the basis of the figures in the annual report.
Page 7
Companies also require financial statements in order to pay tax.

It would be difficult for tax authorities to know how much to levy without
formal financial statements.
END OF EXAMINERS REPORT
Page 8
EXAMINATION
9 September 2005 (am)

Core Technical
booklet.
supervisor.
question paper.
CT2 S2005 Institute of Actuaries
correct.
1 The following information is available for A Ltd:
Authorised shares Issued shares

25p ordinary shares £2,000,000 £1,000,000
6% 50p preference shares £500,000 £250,000
In addition to providing for the preference dividend for a financial year, an ordinary
dividend of 2p per share is to be paid. What is the total amount of dividends for the
year?
A £35,000
B £95,000
C £110,000
D £190,000 [2]
2 Which of the following is NOT true of a Limited Liability Partnership (LLP)?
A A LLP must have a Memorandum and Articles of Association.

B Any firm consisting of two or more members may be a LLP.
C The LLP is a separate legal entity.
D A LLP is treated in the same way as a partnership for taxation purposes.
[2]
3 Which of the following is NOT true of the Internal Rate of Return (IRR) method of
project appraisal?
A IRR can sometimes have mutiple solutions.
B IRR is less popular than Net Present Value as a measure of project worth.
C IRR has the benefit of highlighting the return achieved by the project.
D IRR is the most realiable means of choosing between mutually exclusive

projects.
[2]
CT2 S2005 2
4 You have a diversified portfolio. You are offered an opportunity to invest in an oil
exploration venture in the South Atlantic. Which of the following risks associated
with this project is a systematic risk?
A Bad weather might hamper operations until the cash runs out.
B The geological surveys which suggest the existence of oil might be wrong.
C The price of crude oil on the world markets might fall, making any finds
uneconomic.
D Interest rates might rise, pushing up the costs of borrowing for the enterprise.
[2]
5 During the year ended 30 September 2002 a company bought a fixed asset for
£125,000. The company charges depreciation at the rate of 20% per annum on the
reducing balance basis, with a full year s depreciation in the year of acquisition and
none in the year of disposal. During the year ended 30 September 2005 the asset was
sold for £45,000.
What was the loss on sale of the asset?
A £5,000
B £6,200
C £19,000
D £35,000
[2]
6 The purchase of a business for more than the aggregate of the fair value of its separate
identifiable assets less liabilities results in the creation of a:
A share premium account

B reserve account
C suspense account
D goodwill account
[2]
CT2 S2005 3 PLEASE TURN OVER

7 Which of the following best describes a bulldog ?
A A bond denominated in sterling on an overseas bond market, issued by a UK

company.
B A bond denominated in the local currency on an overseas bond market, issued

by a UK company.
C A bond denominated in sterling on the UK bond market, issued by a foreign

borrower.
D A bond denominated in its local currency on the UK bond market, issued by a

foreign borrower.
[2]
8 Q Ltd has a stock turnover of 40 days, debtors turnover of 45 days and creditors
turnover of 47 days. How long, on average, does each £1 invested in working capital
stay tied up?
A 38 days
B 42 days
C 85 days
D 132 days
[2]
9 Which of the following is NOT a valid ratio for the calculation of return on capital
employed?
Net profit before tax and interest

A
Share capital + reserves + long term debt
Net profit before tax

B
Share capital + reserves
Net profit before tax

C
Share capital + reserves + long term debt
Net profit before tax and interest

D
Total assets
[2]
CT2 S2005 4
10 A company has had a substantial overdraft for several years. When is this loan likely
to become repayable in full?
A At the end of the period specified in the overdraft facility.

B At the bank s discretion.
C At the company s discretion.
D Never.
[2]
11 Explain why quoted companies might make scrip issues as they raise no finance and
they involve some cost. [5]
12 A company s external auditor has warned that the next audit report might be
qualified unless the financial statements are amended prior to publication. Explain
the significance of a qualified audit report. [5]
13 The board of a quoted company has asked for a report on the cost of equity finance.
Explain one method of estimating the cost of equity, identifying the assumptions
inherent in the method. [5]
14 The group finance director of a major quoted company has approached a bank for a
substantial loan to the group. Explain why the financial statements of the individual
companies in the group might be a more suitable basis for the loan negotiations than
the consolidated financial statements prepared by the company. [5]
15 Agency theory underpins many of the theoretical models used in finance. Explain the
logic underlying agency theory, briefly referring to the role of monitoring in
managing the relationship between principal and agent. [5]
16 The following ratios have been calculated from the financial statements of two
companies of similar size that operate in the same industry:
D plc P plc
Return on capital employed 14% 11%
Gross profit % 40% 60%
Net profit % 32% 54%
Explain why most commentators would regard D plc as the more profitable company.
[5]

17 Much of the recent discussion of the role of the firm deals with a range of stakeholder
interests, rather than the previous emphasis on the shareholder only. Identify two
stakeholders other than the shareholders and briefly explain why their interests might
conflict with those of the shareholders. [5]
18 Many large companies issue debentures as a means of raising long term finance.
These are often quoted on the stock exchange. Describe the risks associated with
investing in such debentures. [5]
19 A major quoted company has announced that it has amassed a cash mountain . It
proposes to return this cash to the shareholders 18 months after the date of the
announcement. Rather than do so by means of a dividend, the company will buy a
proportion of each shareholders shares back at a small premium to the prevailing
market price.
(i) Explain why management might want to return cash to the shareholders
instead of retaining it in the company. [4]
(ii) Explain how the company s share price might react to this purchase:
(a) on the announcement of the buy-back

(b) at the time of the buy-back
[8]
(iii) Explain why the company might have chosen to purchase shares rather than
make a dividend payment of the same amount. [4]
(iv) Explain why the company has announced this transaction 18 months in
advance. [4]
[Total 20]
CT2 S2005 6
20 The following balances have been extracted from the books of JK plc, as at 31 August
2005:
£000
Advertising 90
Cash at bank 8
Creditors 52
Debtors 134
Directors remuneration 85
Head office running costs 200
Interest on long term loans 9
Investment income 20
Investments (long term) 450
Long term loans 400
Materials and other manufacturing costs 800
Ordinary dividend paid 60
Ordinary share capital 900
Plant and machinery cost 250
Plant and machinery depreciation at 31 August 2004 100
Premises cost 1,200
Premises depreciation at 31 August 2004 15
Profit and loss at 31 August 2004 374
Sales 2,200
Stock at 31 August 2004 210
Wages and salaries administrative staff 110
Wages and salaries manufacturing staff 400
Wages and salaries sales staff 55
Additional information:
1. Premises are to be depreciated at the rate of 2% on cost and plant and

machinery at 20% reducing balance.
2. Corporation tax based on the year s profit is estimated at £25,000.
3. The company s ordinary share capital is 900,000 £1 ordinary shares, fully

paid. The directors have proposed that no final dividend will be paid.
4. Stock at 31 August 2005 was £180,000.
(i) Prepare JK plc s profit and loss account for the year to 31 August 2005, and a
balance sheet at that date. These should comply with Companies Act
presentation requirements. [15]
(ii) Explain how the estimated corporation tax on the year s profits would have
been calculated. [5]
[Total 20]
END OF PAPER
CT2 S2005 7
EXAMINATION
September 2005

Core Technical
EXAMINERS REPORT
Subject CT2 (Finance and Financial Reporting Core Technical) September 2005 Examiners Report
1 B
2 A
3 D
4 D
5 C
6 D
7 C
8 A
9 C
10 B
11 The arguments to support scrip issues are largely psychological.
Marketability: By having more, lower priced shares, the marketability is improved.
Something for nothing: Shareholders might like the idea of being given extra shares
free of charge.
Past profitability: Scrip issues can take place only if there are sufficient reserves to be
capitalised. This means that scrip issues tend to be associated with successful
companies which have built up large reserves from retained profits.
Future confidence: The minimum price at which a rights issue can occur is the par
value of the shares. Yet rights issues must occur at a discount. Therefore, a rights
issue is only possible if the current share price is above the par value of the shares. A
scrip issue reduces the price of a share. Therefore, having a scrip issue may reduce a
company s ability to have a future rights issue if its share price declined following the
scrip issue. So, if the directors decide to have a scrip issue, they must be confident
about the company s future prospects.
Increased dividends: Some companies have a habit of having light scrip issues
(e.g. 1 for 10) and subsequently keeping the same dividend per share. In these cases, a
scrip issue may lead to, or be a sign of, higher dividends.
More reasonable rate of dividend: If dividends are expressed as a percentage of the

nominal value the figure may seem excessive. This could cause public relations
problems, or problems with employees who feel that dividends are too high. This
could be avoided by a scrip issue.
It is a requirement of the Companies Act 1985 that a company must have a minimum
issued share capital of £1m before it can act as a trustee. A scrip issue converts
reserves into share capital, so may allow a company to meet this requirement.
Page 2
12 A qualified audit report means that the auditor has expressed some reservations about
the truth and fairness of the financial statements.
The most common reason for a qualified report would be that the auditor disagrees to
a material extent with the information in the statements.
The audit report would normally state that the financial statements give a true and fair
view except for the subject matter of the disagreement.
In extreme cases the auditor might state that the financial statements do not give a true
and fair view.
The significance of such an audit report depends on the reaction of readers. In

principle, they must decide whether to rely on the figures provided by the directors or
the auditor.
The fact that the auditors have disagreed with the directors so publicly might
undermine investor confidence in the integrity of the board
and so the share price might fall.
The directors might also be left with a weaker reputation in future years.
13 One approach to deriving the cost of equity is based on the capital asset pricing
model.
Cost of equity = Risk free rate + (Equity risk premium Beta for stock).
The risk free rate is determined by analysing the real rates of return on risk-free
investments such as government securities.
The equity risk premium is determined by the historical average return on equities.
The beta is determined by analysing the historical sensitivity of the return on the
company s securities to the returns on the market as a whole.
If the company s returns fluctuate more widely than market returns the company s
shares will be regarded as more risky and a higher rate of return will be required.
This model assumes that historical sensitivity is a valid measure of the market s
perception of the future risk.
It also assumes that the markets are interested only in systematic risk.
Note accept alternative models such as dividend growth or APT, even if not
covered in core reading.
14 The group has no legal identity; it is merely an accounting abstraction.

It is not possible to enter into a contract with the group as such, only with one or more
of the individual companies in the group.
Each group member is protected by limited liability and is not liable for the debts of
its fellow group members.
Lenders might ask for guarantees so that group members had a contractual duty to
support their fellows.
Page 3
That will only be effective if the funds in the group are freely available for that
purpose. For example, an overseas subsidiary might be unable to remit funds to the
head office.
Or the minority shareholders in a subsidiary might be able to interfere with a transfer

to another group member.
The financial statements for a group of companies are more complex than those for an
individual company, which are usually easier to understand.
15 Agency theory, which considers the relationship between a principal and an agent of
that principal, includes issues such as the nature of the agency costs, conflicts of
interest (and how to avoid them) and how agents may be motivated and incentivised.
These issues arise because the principal must put the agent in a position of trust, but
the agent will usually have an incentive (or at least a perceived interest) to act in his
or her own interests at the expense of the principal s.
The need to rely on agents arises because of the development of a commercial

environment which requires the separation of ownership and control.
Many companies are simply too large and complex for them to be funded by a small
group of shareholders and managed by the same small group.
In practice, the various mechanisms for making the agent s interests coincide with
those of the principal are flawed.
This means that principals often have to rely on monitoring the actions of the agents
with the underlying threat of some penalty for failure or poor performance.
The annual report is often viewed as a means of the agents (directors) demonstrating
their stewardship of the principals (shareholders ) investment.
16 Return on capital employed is normally regarded as the most reliable measure of

profitability.
Given a certain level of investment, it is always better for the business to generate the
highest possible return on that capital.
Other ratios might give an insight into profitability, but they can be difficult to
interpret in isolation.
For example, the higher gross profit % in P plc implies that it makes more profit from
every £1 of sales.
That does not necessarily mean that the company is better managed because it could
be overpricing its sales in order to achieve that result.
Similarly, the net profit % figures suggest that P plc is spending less on non-trading
operating expenses than D plc,
but that could be a false economy. D plc might be making a conscious investment in
better administrative systems and in promotion and advertising and that might be a
further explanation for the higher returns that it is enjoying.
Page 4
17 Employees are generally regarded as stakeholders,

as is government.
Employees are interested in the company s ability to offer them satisfactory terms and
conditions of employment and in their job security.
The shareholders are usually more interested in making a profit and might be keen to
see the company outsource some tasks or even move them offshore.
The government is interested in the company s social and economic contribution and
also its ability to pay taxes.
Again, the shareholders might prefer to have the company relocate to an easier tax
regime or to claim substantial grants and other support in order to obtain higher
profits and dividends.
Credit was also awarded for discussion of other stakeholders (e.g. directors,
creditors, debtors).
18 Debentures are normally secured against assets and so there is very little risk of
default.
This security might be a fixed charge against specific assets or a floating charge over
the assets generally.
Regardless of this, the debenture holders normally rank ahead of most other creditors
in the event of a default.
The debenture will normally give the holder the right to a fixed annual or six-monthly
interest payment.
If this is not paid then there are normally clear agreements to enable the holder to
force the company to make payment.
Debentures are not totally risk free investments, though. Their value arises from
providing a highly predictable series of cash flows. The value of that series will
fluctuate in accordance with the risk-free rates offered on the markets.
If interest rates rise then the cash flows from the debenture will have to be discounted
at a higher rate and a capital loss will ensue.
19 (i) The most likely explanation is that the directors do not have sufficient positive
NPV projects to invest in.
Retaining the cash in the company without putting it to good use will
undermine their return on capital employed.
That would lead to dissatisfaction from the shareholders
and could even lead to an attempted takeover.
The distribution might also demonstrate the integrity of the board.

They are clearly good stewards if they prefer to act in the shareholders best
interests rather than hoard cash for their own sake.
Page 5
(ii) (a) The stock market reaction will depend on the interpretation of the
facts. Presumably the fact that the company had substantial cash
reserves was known.
The market would have had some expectations that this cash would be
put to some use.
If the market believed that the funds would be invested in highly
profitable projects then the announcement that they will be returned as
a cash distribution will depress the market price.
If the market had lacked confidence in management s ability to invest
these funds successfully then the share price might rise.
For example, the market might have anticipated that this cash would be
used to fund some expansion through takeover. This usually involves
considerable expense and takeovers are rarely wholly successful.
In the short term, the stock market might take some time to adjust to
this announcement. It is an unusual step and it might be regarded as a
lack of self-confidence on the part of management.
(b) The share price will fall just after the payment because the company
will be buying the shares back at a small premium.
By the time of the repurchase the shares will have value partly because
of the repurchase
and partly because of the future cash flows to be generated from the
remainder of the company.
(iii) If the company paid a major dividend then the shareholders would have to pay
income tax on the whole amount.
The repurchase will constitute a partial disposal, and any profit will be subject
to capital gains tax.
That is often less onerous, particularly for individual tax payers. Depending on
the original cost of the shares, some shareholders might even make a capital
loss on this disposal and so there will be no tax liability.
The directors might also wish to ensure that this is viewed as a highly
abnormal event.
The use of an unusual form of distribution might help to signal that the
company will not be making any similar disbursements in the foreseeable
future.
(iv) The advance warning will avoid any panic-stricken reactions.

The time scale makes it clear that there will be ample opportunity for
consultation and discussion,
including at least one annual general meeting.
The period of warning will also enable investors to make their own
arrangements in the meantime. Those wishing to avoid recognising a capital
gain in 18 months time will have the option of selling their holding now
and possibly spreading the capital gain. They will also be able to start
planning how best to invest or manage the cash that will be released.
Page 6
20 (a)
JK plc
Profit and Loss Account
for the year ended 31 August 2005
£000 £000
Sales 2,200
Cost of sales (1,284)
Gross profit 916
Administration (395)
Distribution (145)
(540)
Operating profit 376
Income from investments 20
Interest (9)
Net profit before taxation 387
Taxation (25)
362
Dividend (60)
302
Balance brought forward 374
676
Page 7
JK plc
Balance Sheet
as at 31 August 2005
£000 £000
Fixed Assets
Tangible 1,281
Investments 450
1,731
Current Assets
Stock 180
Debtors 134
Bank 8
322
Creditors: amounts due within one year

Taxation (25)
Creditors (52)
(77)
Net current liabilities 245
1,976
Loan (400)
1,576
Share capital 900

Profit and loss account 676
1,576
Page 8
Note Fixed Assets

Cost Aggregate Net book
depreciation value
£000 £000 £000
Land and buildings 1,200 (39) 1,161
Machinery 250 (130) 120
1,450 (169) 1,281
Workings
Cost of sales
Opening stock 210
Materials 800
Closing stock (180)
830
Depreciation (30 + 24) 54
Wages 400
1,284
Admin
Directors' salaries 85
Head office running costs 200
Wages 110
395
Distribution
Advertising 90
Wages 55
145
(b) Companies are liable to corporation tax on their taxable profits.

Taxable profits include both income (less expenses) and capital gains.
The starting point for a company s tax assessment is profit on ordinary

activities before taxation.
This figure then needs to be adjusted.
The main adjustments are:
add back any business expenses shown in the accounts which are not
allowable for tax
add back any charge for depreciation, and instead subtract the allowable
capital allowance
Page 9
deduct gross franked investment income
Franked investment income is income paid by UK companies as a distribution

of their post-tax profits together with an attaching tax credit. The company
paying the dividend has already paid corporation tax on the profits from which
the dividend is paid. The purpose of the tax credit is to reflect the fact that the
dividend is paid from post tax profits.
Page 10
EXAMINATION
6 April 2006 (am)

Core Technical
booklet.
supervisor.
question paper.
CT2 A2006 Institute of Actuaries
correct.
1 It has been suggested that capital markets can motivate directors to maximise the
financial performance of their companies. Which of the following is likely to have the
most immediate effect on directors motivation?
A Companies with poor performance might pay more interest on new

borrowings.
B Poor performance can lead to lower credit ratings.
C All companies are in competition for limited investment funds.
D Declining share price makes the company vulnerable to takeover.

[2]
2 Bank overdrafts can remain outstanding for many years. When does a bank overdraft
normally become repayable?
A At the request of the bank.
B At the conclusion of the term agreed when the overdraft facility was first
granted.
C After five years.
D When the company s gearing ratio exceeds agreed limits.

[2]
3 A limited liability partnership (LLP) was founded by four members, but subsequently
admitted two additional partners. The partnership has become insolvent and has been
wound up owing net debts of £600,000. What is the personal liability of T, one of the
founder partners?
A nil
B £100,000
C £150,000
D £600,000
[2]
CT2 A2006 2
4 A company is considering raising a loan, which would increase the company s
gearing ratio to a significant level, rather than issuing equity. In which of the
following situations would such a decision be most appropriate?
A Interest rates are low.
B The company owns valuable land and buildings that can be pledged as
security.
C The company s operating revenues and costs are relatively stable.
D The company has a good relationship with its principal lender.

[2]
5 A quoted company issued loan stock which is publicly traded. Which of the
following would have no effect on the real rate of return offered by this loan stock?
A A change in the rate of corporation tax.

B A change in the rate of inflation.
C A change in rates offered by Treasury Bills.
D A change in the perceived risk of the company defaulting.
[2]
6 A company evaluates all potential investment projects by ensuring that the internal
rate of return exceeds the company s weighted average cost of capital. Which of the
following reasons is the soundest justification for such a policy?
A Rejects unacceptable proposals.

B Incorporates stock market sentiments.
C Most consistent with finance theory.
D Provides a simple decision rule.
[2]
7 Which of the following is not required by Companies Act 1985 disclosure

requirements?
A Balance sheet
B Profit and loss account
C Cash flow statement
D Directors report
[2]

8 A company s balance sheet excludes the value of a major patent that was registered
after a research breakthrough by its own employees. Which of the following
accounting concepts best justifies the exclusion of this patent?
A Money measurement
B Going concern
C Business entity
D Realisation
[2]
9 Company B has 1,000 shares in issue. An investment bank holds 999 of these. The
remaining share is held by Company A. Company A s share is in a special category
that carries 51% of the voting rights. Which of the following best describes the
relationship between Company A and Company B for consolidation purposes?
A The relationship is immaterial

B Company B is an investment of Company A
C Company B is an associate of Company A
D Company B is a subsidiary of Company A
[2]
10 Which of the following problems is most likely to be overlooked by a ratio analysis of

a company s financial statements?
A Poor profitability
B Liquidity problems
C High gearing
D Substantial contingent liabilities
[2]
11 The directors of a medium sized company are concerned that their gross profit % and
net profit % are both far lower than the industry average. They have asked for
recommendations to improve matters. The company s chief accountant has
responded that the only really important profitability ratio is the return on capital
employed (ROCE) and that, as the ROCE is the highest in the industry, the directors
should not be too concerned about gross profit % and net profit %.
Explain why ROCE might be considered the most important profitability ratio and
explain how a company could have a high ROCE despite poor gross profit % and net
profit %. [5]
CT2 A2006 4
12 A company has, historically, paid a steadily increasing dividend from one year to the
next. The company has had a difficult year and has generated very little profit and
has had slight cash flow problems. The directors are considering borrowing cash in
order to maintain the dividend for the current year in order to maintain the company s
share price.
Discuss the implications for the share price of borrowing to meet dividend
expectations. [5]
13 In theory, companies exist to maximise shareholder wealth. In practice, the

relationship between shareholders and the directors whom they appoint to manage
their companies appears to suggest that the directors have other motives.
Explain why it is difficult for shareholders to be assured that directors are consistently
working to serve their interests. [5]
14 A firm of actuaries has previously operated as a partnership. The firm is considering

raising a large loan in order to buy office premises instead of renting them. One of
the partners has suggested incorporating the firm as a limited company in order to
avoid personal risk for the partners at minimal cost.
Explain whether incorporation as a limited company is likely to achieve the objectives

suggested by the partner.
[5]
15 The directors of a major quoted company are considering raising funds by means of a
rights issue.
Describe the matters that will have to be decided by the directors if they decide to
proceed with the issue.
[5]
16 An investor purchased convertible loan stock in a small company. The exercise

period for converting the stock into equity is two years in the future. However, the
company has written to the investor offering to permit the conversion to go ahead
immediately and on slightly more favourable terms than had been originally offered.
Describe the factors that should be taken into account by the investor in deciding
whether to accept this offer. [5]

17 J is a major company that invests in a range of high technology projects. The chief
financial officer has recommended that all future investment proposals should be
supported by an objective form of evaluation such as the results of a simulation or a
decision tree before the board should even consider whether to proceed with the
proposal.
Explain whether decision aids used in investment decisions are capable of providing
objective decisions. [5]
18 A company has traditionally had a high price / earnings (P/E) ratio. Its directors are
discussing the merits of a new accounting policy that will increase reported earnings
per share. They hope that this will increase the share price when it is multiplied by
the P/E ratio.
Discuss the logic of the directors proposal. [5]
19 A close family member has inherited a sum of money equivalent to two years
payments of his salary. He has decided to invest this sum in shares of the large
quoted company for which he works because he feels that he has a good
understanding of that industry. He wishes to invest this money so that it will achieve
a high yield on his investment, but at minimal risk. He has two children, one of
whom will be going to university in three years time and the other in five years. He
wishes to use his inheritance to support them through their studies.
(i) Explain, using the principles of diversification (as used in the Capital Asset
Pricing Model) how your family member s proposed investment strategy will
lead to a sub-optimal balance between risk and return. [7]
(ii) Explain why it is unlikely that any investment policy will yield a combination
of both a high return and a low risk. [7]
(iii) Your family member is aware that some companies pay substantial dividends
out of earnings and others aim for reinvestment and capital growth. Explain
the tax implications for him of investing for dividends rather than capital
growth. [6]
[Total 20]
CT2 A2006 6
20 The following list of balances has been extracted from the bookkeeping records of
Trolley Ltd at 31 December 2005:
£000
Sales 22,356
Purchases 15,250
Stock at 1 January 2005 1,700
Administrative salaries 1,240
Delivery drivers wages 800
Factory rent, rates and insurance 438
Telephone expenses 420
Advertising 350
Debenture interest paid 70
Factory heat and light 426
Bank overdraft interest 70
Audit fees 150
Preference dividend paid 32
Ordinary shares of 50p each 1,600
8% Preference shares of £1 each 800
Profit and loss account at 1 January 2005 1,360
Bank overdraft 860
10% Debentures 2009 1,400
Property at cost 3,800
Depreciation of property at 1 January 2005 500
Machinery at cost 3,000
Depreciation of machinery at 1 January 2005 900
Delivery vehicles at cost 960
Depreciation of delivery vehicles at 1 January 2005 160
Debtors 1,920
Creditors 690
The closing stock at 31 December 2005 was valued at £ 1,870,000.
Depreciation is to be charged on the following bases:
Property 2% of cost
Machinery 10% of cost
Delivery vehicles 20% of reducing balance
All vehicles are used by delivery and sales staff.
Electricity used in the year but not paid for was £6,000.
Debenture interest unpaid must be provided for, as well as a corporation tax

liability of £500,000.
The annual insurance policy of £90,000 was paid in full to 30 June 2006.

The directors have proposed that the remaining preference dividend be paid in
full, and that a dividend of 5 pence per share be paid to the ordinary shareholders.
Prepare the profit and loss account of Trolley Ltd for the year ended 31 December
2005, and its balance sheet at that date. These should be in a form suitable for
publication as far as possible from the information provided.
[20]
END OF PAPER
CT2 A2006 8
EXAMINATION
April 2006

Core Technical
EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
M Flaherty
June 2006
Comments
Individual comments are shown after each question.
1 D
2 A
3 A
4 C
5 A
6 D
7 C
8 A
9 D
10 D
Comments on question 1 19: Generally Q1 10 were well done by most candidates.
11 Return on capital employed is normally regarded as the most reliable measure of

profitability. Given a certain level of investment, it is always better for the business to
generate the highest possible return on that capital. A high ROCE demonstrates
efficient use of a scarce resource. Other ratios might give an insight into profitability,
but they can be difficult to interpret in isolation. For example, the lower gross profit
% in the company implies that it makes less profit from every £1 of sales. That does
not necessarily mean that the company is poorly managed because it could be for
example pricing its sales aggressively in order to increase market share. In spite of the
lower net and gross profit the company has a high return on capital employed. This
suggests that the company is generating good profits from the capital employed in the
company. The capital employed must be relatively lower than others in the industry
and is being used effectively.
Comments on question 11: This question was answered well by most candidates. Very good
knowledge of the return on capital employed ratio was displayed by many candidates.
12 As the company normally pays a steadily increasing dividend it would be a bad signal
to the shareholders if it decided to pay no dividend. The shareholders may lose
confidence in the company and decide to sell their shares. Borrowing to pay a
dividend may not help because the shareholders might interpret this as a sign that the
company is living beyond its means . The suspended dividend would really only
draw attention to the fact that the company is in a period of poor profitability.
Borrowing would also increase gearing which would make the downturn in profit
appear all the more alarming. The interest on any borrowing will also have to be paid
out of future profits, making the return to a normal dividend all the more difficult. The
only advantage to borrowing is that the directors might be able to argue that the need
to repay the loan indicates that they are confident of returning to profit.
Comments on question 12: This question was also very well answered by most candidates.
Excellent knowledge of the agency problem was demonstrated.
Page 2
13 Agency theory, which considers the relationship between a principal and an agent of
that principal, includes issues such as the nature of the agency costs, conflicts of
interest (and how to avoid them) and how agents may be motivated and incentivised.
These issues arise because the shareholders must put the directors in a position of
trust, but the directors will usually have an incentive (or at least a perceived interest)
to act in his or her own interests at the expense of the principal s. For example by
taking a high salary from the company and paying a lower dividend.
The need to rely on directors arises because of the development of a commercial
environment which requires the separation of ownership and control. The directors
run the company on behalf of the shareholders who own it. Many companies are
simply too large and complex for them to be funded by a small group of shareholders
and managed by the same small group.
The principals often have to rely on monitoring the actions of the agents with the
underlying threat of some penalty for failure or poor performance. The annual report
is often viewed as a means of the agents (directors) demonstrating their stewardship
of the principals (shareholders ) investment. However it is often difficult to
determine whether the directors have improved matters short term but have sacrificed
long term gains to achieve this.
Comments on question 13: This question was also very well answered by most candidates.
Excellent knowledge of the agency problem was demonstrated.
14 In theory, incorporation would limit the liability of the actuaries. Lenders would have
a claim against the company s assets but not those of the individuals who own it. This
advantage could prove costly though. Lenders will perceive a higher risk. They might
respond by charging a higher rate of interest which will, eventually lead to lower
profits for the consultants. They might also seek additional security over assets,
thereby imposing some constraints on the consultants freedom to trade. They might
even demand personal guarantees from the consultants so that they become liable for
the loans despite the incorporation.
Even if the lenders did not take action to protect themselves, limited companies are
subject to some additional regulatory requirements that have to be set against the
benefits of limited liability. For example, limited companies are subject to some
reporting and filing requirements that partnerships are not. This would involve paying
to put trading information in the public domain, where it might prove useful to
competitors or other parties. It appears that incorporation would be costly and may not
result in limited liability.
Comments on question 14: Again this question was answered well. Many candidates also
discussed the benefits of a limited liability partnership, which demonstrated a good
knowledge of the core reading and its application to different scenarios.
Page 3
15 Firstly, the directors will have to appoint a suitable finance house to make the
necessary arrangements and to provide advice and support as required. The timing of
the issue will have to be considered, as well as how much is required to be raised.
Ideally, the funds will have to be raised just before they are required, although there
could be issues associated with timing such as the state of the markets or the
uncertainties created by other matters (such as a forthcoming earnings announcement)
that might upset the markets. The directors will have to decide on the size of the
discount to be offered. In theory, this should have no effect on the shareholders, but
there could be some market psychology at work. The directors will also have to
decide whether or not to have the issue underwritten.
Comments on question 15: This question was answered well.
16 The company s stated reasons should be examined. This offer appears to offer a
concession, but it may be that it is intended to help the board survive a cash shortage
or some other problem with profitability. The investor should also consider the
strength of the company. At present the bond provides most of the rights associated
with holding loan stock. There is more security associated with leaving the investment
as it is. The company s prospects should be reviewed in some detail. If the company
appears to be expanding and is paying acceptable dividends then the conversion could
be advantageous. If the investor converts the interest on the bond will be foregone and
so the interest rate should also be factored into the decision.
Comments on question 16: This question was not answered as well as some others. Some
candidates wrote about bonds in general but very little about conversion, they did not
achieve high marks for this question.
17 Probability trees and simulations are used to organise complex decisions where the
choices available at any stage will be affected by decisions made at earlier stages. For
example, a company can invest in an investment opportunity. Before committing
itself it can decide whether or not to purchase a report which will cost a great deal but
will enable the company to make a more reliable assessment of the project. A
probability tree or simulation will enable management to decide whether it is better to
go ahead or abandon the project without buying the report or whether to buy the
report before making a decision.
The probability tree or simulation would involve the following steps which would not
be objective as they each involve subjective judgement.
assigning estimated cash flows associated with each future possible choice
estimating the probabilities associated with each future cash flow
using standard expected value calculations, incorporating both the time value of
money and the probabilities, to assess the optimal choices in each future time
period based on the knowledge of the intervening events
working backwards from the latest decision point to the present day in order to
establish the best (e.g. highest NPV) route to follow at the outset
Page 4
It is impossible for the result to be anything but an estimate when so many subjective
figures are used to arrive at a result.
Comments on question 17: This question was not answered very well. Few candidates
mentioned the subjective nature of any predictions of future cash flow. Some candidates
mentioned being objective but a discussion of the subjective nature of the whole model would
have improved the answers.
18 The P/E ratio is an important indicator of the stock market s opinion of a company s
prospects. It is largely determined by the share price, which is a function of the
market s expectations of future cash flows. Increasing the profit figure by adopting a
new accounting policy could have no effect on share price because that will not
improve the prospects of increased cash flows. Thus, artificially increasing earnings
per share though an accounting change is more likely to reduce the P/E ratio because
the share price is unlikely to change if everything else stays the same.
It is possible that the accounting change will lead to a short-term increase in share
price while the market takes time to reflect on the effects of the new policy. In
principle, if the effects of the new policy were difficult to measure then this could
continue for some time, but the market is driven by analysts who have a strong
incentive to find such changes and to sell over-priced securities, so the effects of
accounting policy changes are unlikely to be more than short-lived.
Comments on question 18: This question was answered very well by most delegates. Very
clear discussion of the P/E ratio by almost all candidates which was good.
Page 5
19 (a) Portfolio theory states that the return offered by an individual investment is
related to the risk associated with it. Risk is measured in the context of
systematic risk only, because unsystematic risk can be cancelled by
diversification. The market will not offer a reward for accepting unsystematic
risk because it can be dealt with at zero cost. The fact that the investment is to
be in the relative s employer makes the risks even worse because a downturn
could affect both the investment and job security. There is even a cost
associated with attempting to manage an investment in the active way implied
by the relative. Using knowledge of the business implies a trading strategy
based on gathering and evaluating information. A buy and hold strategy based
on a diversified portfolio would reduce the need to make decisions about
buying and selling shares and should save on information and trading costs.
(b) The capital markets offer a return that compensates for deferring consumption
(roughly 2% in real terms), plus a premium for risk. Market forces set a fair
price for the risks taken. An investment that offered a higher return than was
justified by the risk taken would be underpriced. Investors would realise this
and would buy the security, thereby pushing up the price. That would reduce
the return offered by the security to its equilibrium price. Speculators and
arbitrageurs monitor the financial markets for mispriced securities so that they
can make short-term profits. In theory, capital markets are efficient, which
means that securities will always be correctly priced at all times.
(c) The family member will be taxed on any dividend at his marginal rate of
income tax. That tax will be almost impossible to avoid and he will have
relatively little control over the timing of receipts and, by implication, of
taxable income. The taxation of capital gains is rather more complicated.
Firstly, the gain will not be taxed until the shares are sold and the gain is
realised. That, in itself, gives the taxpayer more discretion over the
management of payments to the tax authorities. Taxpayers also have separate
annual allowances for capital gains, quite separate from allowances from
income tax. If a realised gain is less than the annual allowance then the gain
will be effectively tax free. In some cases, the chargeable gain will be reduced
by an indexing allowance to adjust for the effects of inflation.
Comments on question 19: This question was very poorly answered. A number of candidates
answered part a by discussing CAPM and did not mention portfolio theory. Few candidates
appeared to have heard about efficient markets and had very poor answers for b. C was very
badly answered by all but the best candidates. The best candidates gave excellent answers
but the rest had difficulty with this question. It would be beneficial to have knowledge of this
part of the syllabus for the future.
Page 6
20 Trolley Ltd
Profit and loss account for the year ended 31 December 2005
Note £000
Turnover 22,356
Cost of sales 1 (15,905)
Gross profit 6,451
Distribution costs 2 (1,310)
Administrative expenses 3 (2,186)
Operating profit 2,955
Interest payable 4 (210)
Profit on ordinary activities before taxation 2,745
Taxation (500)
Profit on ordinary activities after taxation 2,245
Dividends paid (32)
Dividends proposed 5 (192)
Retained profit for the year 2,021
Retained profit brought forward 1,360
Retained profit carried forward 3,381
Trolley Ltd
Balance sheet as at 31 December 2005
Note £000 £000
Fixed assets
Tangible fixed assets 6 5,664
Current assets
Stock 1,870
Debtors 7 1,965
3,835
Creditors: amounts falling due within one
year 8 (2,318)
Net current assets 1,517
7,181
Creditors: amounts falling due after more
than one year
10% Debentures 2009 (1,400)
5,781
Share capital and reserves

Called up share capital 2,400
Profit and loss account 3,381
5,781
Page 7
Working Notes
£000
1. Cost of sales
Opening stock 1,700
Add: purchases 15,250
Factory rent rates and insurance (438 - 6/12 * 90) 393
Heat and light (426 + 6) 432
Less: closing stock (1,870)
15,905
2. Distribution expense
Van drivers wages 800
Advertising 350
Depreciation delivery vehicles 160
(20% (960 160)) 1,310
3. Admin expenses
Admin wages and salaries 1,240
Telephone 420
Audit fees 150
Depreciation property (2% 3.8m) 76
Depreciation machinery (10% 3,000k) 300
2,186
4. Interest
Debentures (10% 1,400k) 140
Bank overdraft interest 70
210
5. Proposed dividends
Ordinary 3.2m shares @ 50 pence 160
Preference ((8% 800) 32) 32
192
6. Tangible fixed assets

Property Plant and Vehicles Total
Machinery
£000 £000 £000 £000
Cost at 1 Jan 2005 3,800 3,000 960 7,760

Depreciation at 1 Jan 2005 500 900 160 1,560
3,300 2,100 800 6,200
Depreciation charge for the year 76 300 160 536
WDV at 31 Dec 05 3,224 1,800 640 5,664
Page 8
7. Debtors
£000
Trade debtors 1,920

Insurance prepayment 45
1,965
8. Creditors due within one year £000
Trade creditors 690

Electricity accrual 6
Debenture interest 70
Corporation tax 500
Proposed dividends 192
Bank overdraft 860
2,318
Comments on question 20:
This question was answered well apart from the accrual and prepayment, which caused some
problems. Generally the question was well done and most candidates got high marks.
It was good to see so many candidates can prepare a set of accounts and have awareness of
the format.
Overall the paper was answered well by many candidates. There were some fairly small
areas, which caused problems but overall it was heartening to see good performances by so
many candidates.
Page 9
EXAMINATION

Core Technical
booklet.
supervisor.
question paper.
CT2 S2006 Institute of Actuaries
correct.
1 Within the UK, accounting standard setting evolved largely as a consequence of:
A the UK joining the European Union

B a lack of public confidence in the accounts prepared by accountants
C the formation of the Financial Reporting Review Panel
D company directors wishing to provide consistent information
[2]
2 The following statements relate to different types of business structures:
I Limited companies pay income tax on their profits.
II Partnerships are required to have a partnership agreement that sets out the
rights of individual partners.
III A Limited Liability Partnership is a separate legal entity.
IV Sole traders may have employees working for them.
Which of the above statements are correct?
A I and III only

B I, II and III only
C III and IV only
D I, II and IV only
[2]
3 ABC Ltd started trading on 1 January 2005 and has a gross profit margin of 24%. It
made sales of £184,650 during the year to 31 December 2005 and made purchases of
£178,600. What is ABC Ltd s closing stock?
A £38,266
B £40,316
C £138,488
D £142,334
[2]
CT2 S2006 2
4 If the auditor of a company cannot obtain sufficient evidence to give an opinion on
whether or not the company s financial statements give a true and fair view, the
auditor should issue:
A an adverse opinion
B a disclaimer of opinion
C an unqualified opinion, but include a reference to this matter in the audit
report
D an unqualified opinion
[2]
5 Which of the following statements is NOT true of investment trusts?
A They are public companies.

B They can raise both loan and equity capital.
C They are open-ended investment vehicles.
D Their shares are usually quoted.
[2]
6 Agency theory identifies certain types of cost as agency costs.
I Directors salaries
II Directors bonuses
III The auditor s fee
IV Employees pay rises
Which of the above would be an agency cost?
A I and II only
B I, II and III only
C II and III only
D All of the above
[2]
7 Which of the following is NOT true of Eurobonds?
A They are issued in Euros.

B They can be issued by a company or government.
C They are traded through banks.
D They are international bonds.
[2]

8 Project XYZ requires an initial cash outlay of £50m. It was initially believed that this
investment would create cash inflows of £16m in each of the following three years,
and £12m in each of the next two years, after which the project would be complete.
The payback period and internal rate of return of the project were calculated for the
project. A further review of project cash flows indicated that the final cash flow in
year five had been overestimated, and would probably be only £4m. What effect
would this have on the two calculations?
Payback period Internal rate of return
A Unchanged Decrease
B Unchanged Increase
C Increase Decrease
D Increase Increase
[2]
9 A business made a loss during the financial year just ended but has more cash at the
end of the year than it did at the beginning. Which of the following could be a reason
for this?
A Dividends were lower this year than last year.

B Some fixed assets were sold during the year.
C Debtors took longer to pay this year than last.
D Creditors were lower at the end of this year.
[2]
10 Which of the following is NOT true in relation to company taxation?
A Interest payments are tax deductible.
B Capital allowances are added to the company s accounting profit.
C Lease of plant and equipment attracts tax relief.
D Companies with overseas income may be able to offset tax paid overseas
against their liability to UK corporation tax.
[2]
11 Companies dividend policies often make explicit assumptions about the tax
implications for their shareholders for dividends rather than capital growth.
Compare and contrast the tax treatment of dividends versus capital gains on equity
investments. [5]
CT2 S2006 4
12 A firm of actuaries wishes to raise some medium term finance in order to acquire
some new computer equipment.
Compare TWO forms of medium term finance that they could use. [5]
13 In theory, companies exist to maximise the wealth of their owners.
Explain the problems associated with demonstrating that companies actually do

operate in such a way as to maximise their shareholders wealth. [5]
14 Financial futures take many different forms.
Explain the reasons for the existence of such financial instruments. [5]
15 Share issues are often, but not always, underwritten.
Explain the factors that have to be considered by the directors in deciding whether or
not to have an issue underwritten. [5]
16 The directors of G are deciding whether or not to invest in a major building project.
They have used a Monte Carlo simulation process to model the cash flows from this
project. They have run the simulation 10,000 times. The average net present value of
the project is positive and the project has generated a positive net present value on
9,930 occasions.
Explain how such a simulation exercise might be created. Your answer should
indicate the factors that would be incorporated into the simulation model.
[5]
17 Company financial statements contain many figures that are really matters of opinion
rather than fact. The figures for tangible fixed assets are subject to a variety of
estimates and assumptions.
Explain the role of estimates and assumptions in arriving at the figures for tangible
fixed assets in company balance sheets. [5]
18 One of the biggest problems arising from the preparation of consolidated financial
statements is the identification of subsidiaries and associates.
Explain how holding companies identify subsidiaries and associates. [5]

19 K plc has a weighted average cost of capital (WACC) of 12%. The directors are
planning the acquisition of a factory and the rights to manufacture a new product line
that would extend the company s product range.
The directors are deciding whether to finance this expansion by borrowing or by the
issue of fresh equity. They have approached several potential lenders and have been
able to secure the offer of a loan at a rate of 9%. This has led to considerable
optimism because they believe that issuing debt will reduce the company s WACC,
thereby making the expansion even more attractive in net present value (NPV) terms.
(i) Explain why management might believe that issuing debt rather than issuing
equity will reduce the company s WACC and explain whether their perception
is necessarily correct. [8]
(ii) Explain why it may be difficult for companies to determine their cost of equity
in order to measure the WACC. [6]
It has been suggested that WACC is not always a suitable basis for calculating the
NPV of a project.
(iii) Explain why this is so and explain how the directors should arrive at a suitable
discounting rate. [6]
[Total 20]
CT2 S2006 6
20 Mr Able, a potential investor, is considering purchasing ordinary shares in Evolution
plc, a company which manufactures toys. Mr Able has approached you for advice.
You are provided with extracts from Evolution plc s financial statements for the
previous two years as follows:
Year to Year to
31 Dec 31 Dec
2004 2005
£000 £000
Sales 2,000 2,600

Purchases 1,570 2,090
Opening stock 350 400
Closing stock 400 550
Expenses 359 474
Tax on profits 29 54
Proposed dividends 42 42
Fixed assets 500 670
Current assets 780 893
Current liabilities 370 563
300,000 ordinary shares of £1 300 300
100,000 8% preference shares of £1.50 150 150
Share premium 10 10
Profit and loss reserves 200 250
12% Debentures 200 200
In addition you are given the following information:
1. All Evolution plc s sales are credit sales, and all its purchases are credit
purchases.
2. Expenses include interest payments.
3. The profit and loss reserve figures are the opening balances.
4. The market value of the company s shares at 31 December 2004 was 175p per
share, and at 31 December 2005 the market value was 225p per share.
Based on your analysis of the information provided, draft a report to Mr Able,

outlining the trading performance and financial position of Evolution plc, stating
whether or not the company is well managed. You should use relevant ratios to
support your analysis. [20]
END OF PAPER
CT2 S2006 7
EXAMINATION
September 2006
Subject CT2 — Finance and Financial Reporting

Core Technical
EXAMINERS’ REPORT
Introduction
M A Stocker
November 2006
General Comments
The results in this diet were disappointing. The marks were lower than usual and the level of
knowledge shown was poorer than in the past.
Many of the questions were similar to previous diets and were answered poorly.
One of the problems was that some candidates did not answer the questions that were asked.
Reading the questions carefully and making sure the answer is relevant is vital.
There were however some excellent candidates who gave good answers and it was heartening
to see the high level of knowledge demonstrated by them.
Other Comments
Individual comments are shown after each question.
© Faculty of Actuaries
© Institute of Actuaries
Subject CT2 (Finance and Financial Reporting Core Technical) — September 2006 — Examiners’ Report
1 B
2 C
3 A
4 B
5 C
6 C
7 A
8 A
9 B
10 B
Comments on questions 1–10: These questions were reasonably well answered though few
candidates got full marks.
11 If the company paid a dividend then the shareholders would have to pay income tax
on the whole amount. Any profit made when shares are sold will be subject to capital
gains tax. Capital gains tax only becomes payable once the shares have been sold and
the gain realised. That provides taxpayers with more flexibility in managing their tax
affairs because they have discretion over when they take the gain. Individual
taxpayers have both income tax and capital gains tax allowances. Many taxpayers will
pay income tax on their dividend income because their other income has exhausted
these allowances. The effective tax rate on capital gains may be reduced or even zero
on the basis that they use their annual exemptions.
Comments on question 11: This question was answered reasonably well. Some candidates
concentrated on discussing franked investment income and got poor marks. It was good to
see so many candidates understood Capital Gains tax.
Page 2
12 Two methods of medium term finance could be bank loans or leasing. Under a
finance lease, the lessee has the right to use the asset over a period of time, in return
for a regular series of payments. The lessee takes on most of the risks associated with
owning the asset e.g. insuring and repairing the asset. The present value of the
payments under the leasing agreement will be shown as an asset in the lessee’s
balance sheet and as a corresponding liability. A 3–5 year bank loan is also a form of
medium term borrowing. The amount of the loan is paid into the borrower’s bank
account and the borrower will repay capital and interest in regular instalments. The
borrower is then free to purchase the asset of his choice and to seek discounts for
paying in cash. Legal ownership of the asset changes hands immediately.
The interest rate implicit in a lease will usually be fixed and can be higher than a bank
loan. The interest rate on a bank loan is usually variable. A bank loan may lead to a
floating charge over all the assets of the company and the asset would form part of
this security. The asset itself usually provides its own security in the case of a lease,
thereby leaving the other assets available as collateral for other purposes.
Comments on question 12: This question was answered well by most candidates. It is
important to make sure the question is answered, some candidates discussed short and long
term finance which got zero marks.
13 The first problem is in measuring shareholder wealth. This is clearly indicated by the
share price, but that can be a volatile indicator, that is not necessarily affected by just
the company’s efforts to manage the shareholders’ wealth. Furthermore, management
decisions that enhance shareholder wealth will only be recognised in the share price
once the decision itself is announced. This information might be withheld for
commercial reasons.
The second problem is that the directors are often perceived as having their own
interests that are at odds with those of the shareholders. They might have an interest in
enhancing their own rewards at the expense of the shareholders or of avoiding
acceptable risks in order to put their job security before the wellbeing of the
shareholders.
Comments on question 13: This question was not done as well as expected. The question was
straightforward but many candidates only discussed the agency problem and so did not get as
high a mark as they could have.
Page 3
14 The principal reason for issuing futures is to enable entities to buy and sell risk, as a
commodity. Futures make it possible to eliminate risk by agreeing to a fixed price for
the acquisition of an asset or the settlement of a liability at a future date. The counter
party to this transaction will benefit by taking the risk in return for a return. Futures
also make it possible to speculate on the size and nature of the volatility in the
underlying commodities. Market participants who believe that they can predict price
movements can often “gear up” such fluctuations by buying or selling futures rather
than the commodities or instruments themselves.
Futures are themselves designed to be traded as financial instruments in their own

right. This facility creates further trading strategies to enable parties to contracts to
modify their positions in a regulated market, with standardised contracts.
Comments on question 14: This question was poorly answered. A significant number of
candidates wrote about different kinds of futures which was not required.
15 Underwriting is a form of insurance and so one important consideration is the

exposure faced by the company if the issue should fail. The directors should consider
the reasons for raising the finance. Withdrawal from a discretionary investment is less
of a problem than withdrawal from one to which the company has made a public
commitment .
The terms of the share issue are important. If the shares are issued at a large discount
to current market prices then there is less risk that demand will fail and so there is less
need for an underwriter. If share prices are volatile then there is a greater risk that
prices will fall below the issue price, thereby rendering the issue a failure and
increasing the need for underwriting.
The cost of the underwriters’ facilities are also an issue. These are likely to be linked
to the risks considered by the directors and so the greater the need for an underwriter
the more expensive the service is likely to be.
Comments on question 15: This question was answered well by most candidates.
Page 4
16 The simplest way to create this model would be to identify the variables that might
affect the cash flows from the project. These would be modelled in terms of
probability distributions, which could be represented by random numbers. Where
factors are independent of one another then there will be a separate series of random
numbers for each, otherwise relationships between factors will be built into the model.
The simulation could then be run many times, with different sets of numbers, until a
consistent average outcome and range of good and bad outcomes starts to emerge.
The cash flows themselves would have to be modelled. The cost structure might have
to be modelled in terms of costs associated with different geological or other
problems that might arise with the contract. The probability of each could be linked to
random number tables. The discount rate will also have to be factored in. Discount
rates and costs might be linked via inflation and so the model might have to use one
set of core random numbers.
Comments on question 16: This question was answered well by many candidates, however
some candidates discussed modelling in general and did not appear to know anything about
Monte Carlo simulation. It is vital that candidates answer the question.
17 The biggest area for estimates and assumptions is with respect to determining the
depreciation charge. The company must estimate the expected useful life of the asset
and its estimated residual value. The company must also make assumptions about the
manner in which the value decreases from original cost to the residual value — more
rapid depreciation in the early years requires the use of the reducing balance
approach.
There are also estimates and assumptions implicit in the capitalisation of costs in fixed
assets. There can be some doubt as to whether expenditure is an ongoing operating
cost (e.g. a repair) or part of the cost of acquiring or improving an asset. Some
specific costs, such as the capitalisation of interest, require assumptions about the
progress being made on the asset at any given time.
Many tangible fixed assets are shown at their market values. Such valuations are
almost always a matter for professional judgement because there is rarely an
observable market price for any particular asset or property.
Assets must also be subject to impairment reviews.
This question was straight from the Core Reading and high marks were anticipated. However
many candidates gave disappointing answers. It was surprising to note that many candidates
appeared to find depreciation confusing.
Some revision in this area would be advisable.
Page 5
18 The principal test is of whether a company is a subsidiary of another is whether

Company A can control Company B. There are some guidelines for the measurement
of control in the Companies Act and accounting standards. This could happen if
Company A has purchased more than 50% of the voting shares. Control might also
arise if Company A can appoint or remove directors to or from the board of Company
B, particularly if it could control more than 50% of the votes at board meetings in this
way. Company A might also be able to exercise a dominant influence over Company
B, for example by entering into a contract that gives Company A the ability to
exercise control. A holding company would normally have between 20% and 50%
ownership and significant interest to be an associate. These terms are difficult to apply
in practice because control can be difficult to measure and to demonstrate.
Comments on question 18: This question was really well answered by almost all candidates.
Well done!
19 (i) In theory, debt is cheaper than equity because lenders take fewer risks. In
theory, borrowing will reduce WACC because of the higher proportion of
debt. In practice, this might be slightly more complicated because borrowing
will affect the gearing levels and that will affect the risk characteristics of
existing equity. Borrowing will increase the risk of holding shares and that
could increase the cost of equity. At higher levels of gearing the risk attached
to debt might also increase and that could increase the cost of borrowing too.
These additional costs will offset the savings from using the cheaper source of
finance.
Borrowing also carries a tax advantage because interest can be offset against
profit whereas dividends cannot.
The Modigliani and Miller argument suggests that the reduction in WACC due
to borrowing will be exactly offset by overall increases in the cost of equity.
This means that there is no particular cost advantage in using debt or equity.
This argument ignores taxation, though.
(ii) The cost of equity is the rate at which the stock market discounts the cash
flows that are expected from the company. It is impossible to observe market
expectations of cash flows. Most models for arriving at the cost of equity use
past information about dividends and the like to estimate a cost of capital.
Each of those models will generate a different answer and will also require
assumptions about anticipated dividends.
The cost of capital model is also based on share prices which are themselves
quite volatile and might be affected by short term speculative and other market
forces. The cost of equity is likely to be a long-term, underlying factor that is
implicit in the short-term sequence of share price movements.
(iii) Every project should be discounted at a rate that reflects the risks to the
shareholders of making the investment. The WACC might be a suitable
surrogate if the project is a straightforward expansion of the business and is
subject to the same risks.
Page 6
The most appropriate basis for the discount rate is to view the project as a
separate investment within a diversified portfolio held by investors. The beta
coefficient of the returns should be estimated and the CAPM should then be
used to determine an appropriate discount rate.
The directors should also consider the stock market’s understanding of the
project . If the stock market thinks that an investment is highly risky then the
share price could go down if the estimated cash flows are subject to a high
implicit discount rate.
Comments on question 19: The first part of the question was answered really well. Parts 2
and 3 were poor. Many candidates just put down the formula for cost of equity and wrote a
very short explanation. Very poor understanding was demonstrated in part 3. Again an area
for revision.
Page 7
20
Report to: Mr Able
Report from: XYZ Financial Advisors
Re: Analysis of Evolution plc’s performance and financial position
Date: X.X.XX
Introduction
In accordance with your instructions we report on the performance and financial
position of Evolution plc for the last two years. Our findings are primarily based
on an analysis of accounting ratios. We would point out that the analysis has
several limitations, since it is based only upon key historical financial
information.
Profitability
The profitability of the company improved over the past two years, with a high
return on shareholders’ equity, and a higher return on investment. The return on
equity has increased from 16% to 21% over the two years, and the return on
investment has increased from 15% to 18%. This shows that the company is
very profitable, as the returns are far better than those offered by risk-free
investments.
The gross profit margin is also healthy and improving, moving from 24% to
25% over the two years. This shows the company is managing its selling prices
and purchasing costs well.
Evolution plc is also controlling its expenses well, having improved its net profit
percentage from 6% in 2004 to 7% in 2005.
Efficiency
Despite the substantial increase in fixed assets during the period (34%), there is
very little change in the fixed asset turnover ratio for the period, both being
around 4 times. The increased investment may reflect replacement of existing
assets or acquisition of additional assets, either of which has given rise to
increased turnover. There may be a further increase in turnover if these assets
have not yet been fully realised.
The net current asset turnover has increased from 4.9 times in 2004 to 7.9 times
in 2005. This indicates a substantial increase in the level of activity being funded
by current assets.
Liquidity
The liquidity position of the company deteriorated over the two year period. The
current ratio fell from 2.1:1 to 1.6:1, and the acid test ratio fell from 1:1 to 0.6:1.
This provides further indication that the 30% increase in sales and the
acquisition of fixed assets was funded from working capital.
The company should raise additional long term finance to ease the company’s
liquidity problems.
There was no change in stock turnover (both years 4.1 times), which suggests
Page 8
that the expansion in sales did not lead to a deterioration in the company’s stock
controls.
Gearing
The company is low geared. The debt /equity ratio was .63 in 2004 and .54 in
2005. This is attractive to an equity investor as it is an indicator of low risk.
The interest cover is very satisfactory at 6 times in 2004 and 8.8 times in 2005.
This is also attractive to an investor, as it indicates that the company has not
fully utilised its potential debt facilities.
Return on investment
The company’s earnings per share rose from 26.7 to 40p over the two years, as a
result of Evolution plc’s increased profitability.
The dividend per share remained constant at 10p per share in both years, despite
the increased profitability. This is an indication that the company will be in a
position to pay higher dividends in future years.
Conclusion
Given the high return being offered by Evolution plc and its low gearing, the
company appears to be well managed.
This question was very badly done.
Candidates showed a poor level of knowledge and could not apply that knowledge to the
question. The bulk of the marks available were for commenting on the ratios. Some
candidates did not comment at all and others wrote very brief answers. In these questions it
is the report that is important and is where the candidates can apply their knowledge to a
scenario.
Candidates should revise this area for the future.
END OF EXAMINERS’ REPORT
Page 9
EXAMINATION
16 April 2007 (am)

Core Technical
booklet.
supervisor.
question paper.
CT2 A2007 © Institute of Actuaries
For questions 1–10 indicate in your answer book which one of the answers A, B, C or D is
correct.
1 A project has an internal rate of return of 12%. It has a positive net present value at
10%. The project will be funded by means of the issue of loan stock, which has
already been arranged and to which the company is committed. The finance raised
from the loan stock issue will cost 8% per annum. If the company does not invest in
the project then it will invest the proceeds in a financial instrument which carries a
rate of return of 6% per annum. What is the opportunity cost of investing in this
project?
A 6%
B 8%
C 10%
D 12%
[2]
2 Which of the following is the best measure of the cost of retained profits in a
business?
A Retained earnings are a cost-free source of finance.
B The cost of retained earnings is the same as that of the weighted average cost
of capital (WACC).
C The cost of retained earnings is the same as that of ordinary share capital.
D The cost of retained earnings is the same as that of secured loan stock.
[2]
3 Which of the following is the most correct summary of the reasons behind Modigliani
and Miller’s argument that capital markets are indifferent to a company’s financial
structure?
A Tax effects undermine the cost of different sources of finance in different

ways.
B Shareholders can adjust gearing at minimal cost.
C Companies must always follow the optimal gearing strategy in order to attract
finance.
D Institutional investors can “see through” the effects of different financing

strategies.
[2]
CT2 A2007—2
4 Which of the following is an economically sound reason for a company to enter into a
share repurchase?
A Earnings per share tends to be inflated.

B Share repurchases can be efficient from a tax point of view.
C Share repurchases are a powerful signal of confidence to the stock market.
D A repurchase is simpler than increasing the dividend.
[2]
5 Which of the following is the most appropriate basis for determining the required rate
of return on a major project being considered by a quoted company?
A The company’s weighted average cost of capital (WACC).
B The interest rate on the bank loan raised in order to finance the project.
C A specific rate for the project determined according to the project’s total risk.
D A specific rate for the project determined according to the project’s systematic
risk.
[2]
6 An external auditor is preparing the audit report on a company’s financial statements.

The auditor believes that the financial statements are potentially misleading unless
readers pay close attention to one of the notes to the accounts. Which form of audit
report is likely to be most appropriate in these circumstances?
A Unqualified opinion.
B Unqualified opinion with emphasis of matter.
C Qualified opinion.
D Disclaimer of opinion.
[2]
7 Which of the following is true of limited liability partnerships (LLPs) in the UK?
A They have no separate legal identity.

B They are taxed as companies.
C They are profit seeking ventures.
D Members have joint and several liability.
[2]
CT2 A2007—3 PLEASE TURN OVER

8 Who bears the responsibility for the preparation of a company’s financial statements?
A The shareholders.
B The finance director.
C The board of directors.
D The external auditor.
[2]
9 Which of the following would NOT be removed from the calculation of a UK

company’s accounting profits in order to arrive at the taxable profit for corporation
tax purposes?
A Overseas earnings.
B Franked investment income.
C Depreciation.
D Entertaining costs and similar expenses that are not allowable for tax.
[2]
10 Finance theory suggests that individuals who own shares often find the tax treatment
of capital gains on shares preferable to the tax treatment of a dividend of the same
amount. Which of the following is NOT a potential reason for this preference?
A Capital gains are not taxed until they are realised.
B Income on dividends is typically taxed in its entirety for taxpayers who have
income from other sources.
C Taxpayers who do not report capital gains are unlikely to be discovered by the
authorities.
D Capital gains are sometimes adjusted by reliefs that take length of ownership
into account.
[2]
11 Explain how and why the interests of the stakeholders in a company may be in
conflict with one another. [5]
12 Explain the differences between the risk management characteristics of options and
futures. [5]
13 Explain how tax might influence the shareholders’ preference for debt financing
versus equity financing in the company’s gearing decision. [5]
CT2 A2007—4
14 A company’s operating profit was £500,000. Depreciation of £150,000 was charged
in arriving at this figure. Comparing the balance sheet at the beginning and end of the
period showed the following movements:
Inventories increase of £30,000

Trade receivables decrease of £10,000
Trade payables increase of £8,000
Calculate the cash generated from operations for this company. [5]
15 A company’s cash flow statement showed that it had sustained a major outflow of
cash, despite the fact that it had made a healthy profit during the year.
Explain how this could be possible. [5]
16 Explain why balance sheets always “balance”. [5]
17 Explain why the going concern assumption may simplify the preparation of financial
statements. [5]
18 Outline the difficulties associated with preparing financial statements that give a “true
and fair view”. [5]

19 The directors of a major quoted company have been working towards a greater spirit
of openness in the interest of improving investor relations. As part of this, they
released a great deal of information about a major investment project that the
company had committed itself to. The directors had conducted a detailed analysis and
were of the opinion that the project’s net present value (NPV) was worth roughly 10%
of the company’s market capitalisation. They were, therefore, disappointed that the
publication of this information had little or no observable impact on the share price.
The published information had not included detailed cash flow projections or details
of the required rate of return used to evaluate the cash flows, but it should have been
sufficient for shareholders to have been able to determine that the project represented
a significant and profitable expansion, with a low risk.
(i) Explain why it is theoretically correct to assume that accepting a project with
a positive NPV should increase the value of a company by the NPV of the
project. [7]
(ii) Explain why the movement predicted in (i) is unlikely to be the case in
practice. [7]
(iii) Explain why companies are often keen to provide shareholders with
information about plans and future prospects. [6]
[Total 20]
CT2 A2007—6
20 The directors of Cash Ltd are in the process of conducting a risk assessment of the
financial aspects of the management of their business. They have decided to analyse
ratios relating to liquidity and gearing and to compare the results with those of similar
businesses.
The company’s latest balance sheet is as follows:
Cash Ltd
Balance sheet as at 31 March 2007
£000
ASSETS
Non-current assets 2,500
Current assets
Inventories 200
Trade receivables 150
350
Total assets 2,850
EQUITY AND LIABILITIES

Ordinary share capital 500
Preference share capital 300
Revaluation reserve 200
Retained earnings 400
Total equity 1,400
Non-current liabilities
Long-term borrowings 1,200
Current liabilities
Trade payables 120
Current tax payable 100
Bank overdraft 30
2,850

The directors have obtained the following averages for ratios based on their
competitors’ financial statements:
• Gearing (based on borrowings/total long term finance) 35%

• Current ratio 2:1
• Quick ratio 1:1
The directors have a secondary reason for their interest in the gearing ratio. The
company’s long-term borrowings are in the form of a bank loan. A condition of the
loan was that the company’s gearing ratio would be kept below a specific percentage.
If the gearing ratio exceeds that limit then the bank has the right to demand immediate
repayment.
The directors have already evaluated the company’s profitability. Cash Ltd’s return
on capital employed is in line with the industry average. The directors are satisfied
that they are as efficient and profitable as the other companies in their industry.
(i) Calculate Cash Ltd’s gearing ratio, current ratio and quick ratio. [4]
(ii) Explain the implications of the ratios and other information provided for the
assessment of the risks faced by Cash Ltd. [10]
(iii) Explain why a bank would impose a loan condition that set a maximum level
for a borrower’s gearing ratio. [6]
[Total 20]
END OF PAPER
CT2 A2007—8
EXAMINATION
April 2007

Core Technical
EXAMINERS’ REPORT
Introduction
M A Stocker
June 2007
Comments
Generally the standard of answers was poorer than usual. Candidates did not appear to be
well prepared for this exam. The standard of questions was similar to previous diets,
however the answers were of a lower standard. The depth of many answers was poor. There
were, as usual, some very good papers which is always heartening.
Further comments, where appropriate, are given in the solutions that follow.
Subject CT2 (Finance and Financial Reporting Core Technical) — April 2007 — Examiners’ Report
1 A
2 C
3 B
4 B
5 D
6 B
7 C
8 C
9 A
10 C
Q1–10 were not answered as well as usual. Very few candidates achieved full marks. There
was no one question that was poor. There were some extremely poor marks which is
unusual.
Candidates need to be well prepared to sit the exam, more revision is required before the
next sitting in September.
11 Stakeholders have conflicting interests due to the commercial realities of the business.
For example, corporate social responsibility is good for the public but may be costly
to the shareholders. Therefore, benefits accruing to one stakeholder group may
impose costs on another. This may be particularly acute when the company has direct
contact with both parties, as when improving employees’ benefits may be expensive
for the shareholders.
A related issue arises from the fact that the interests of different providers of finance
may be in direct conflict. For example, the shareholders enjoy the upside from risky
investments but the lenders do not. A risky investment could be good for the
shareholders, but might undermine the security of the lenders. Similarly, taking on
additional debt in order to finance growth may be in the shareholders’ interests, but
that could dilute the security enjoyed by lenders.
This question was answered well by many candidates.
12 Options give the right to buy or sell the underlying asset, whereas futures require
completion of the transaction at the conclusion of the period. That makes each type of
instrument suitable for dealing with a different type of risk. A future would be
suitable for creating certainty as to the cost of a particular product in the future. For
example, a farmer might use the futures markets to sell a crop for a fixed price at a
specified date. That would mean that the selling price was fixed and the farmer would
be unaffected by a drop in price. However, the farmer could not benefit from any
subsequent increase in the price because delivery would still have to be completed.
An option to sell the product would leave the farmer free to exercise the option if the
price fell below the striking price, but it would also be possible to let the option lapse
and sell at a higher market price. In a sense, the premium paid for an option might be
Page 2
thought of as an insurance policy to protect against a specific downside risk , whereas

a future protects against all risks, good and bad.
This question was poorly answered. Many candidates talked about options in detail,
which was not what was asked for. Read the questions carefully, it is worth spending
a bit of time planning an answer rather than just rushing to answer it. Always try to
answer exactly what is being asked.
13 Corporation tax reduces the profit available to pay the shareholders’ dividend.
Borrowing increases the interest charge, which is deductible as an expense for
corporation tax purposes. Some forms of borrowing are very tax-efficient. For
example, lease payments are tax-deductible and provide a more consistent tax benefit
than the effects of raising finance to purchase assets outright and claiming capital
allowances.
The alternative to borrowing is to raise finance from the shareholders. If the company
makes a rights issue it may be difficult for the shareholders to obtain tax relief on any
funds that they borrow in order to buy shares. The shareholders might prefer the
company to borrow on their behalf because the tax benefit is much less likely to be
lost.
This question was answered well by most candidates.
14
Operating profit £500,000
Depreciation 150,000
Increase in inventories -30,000
Decrease in trade receivables 10,000
Increase in trade payables 8,000
£638,000
This question was poorly answered. Most candidates were unsure whether the
increases and decreases in assets and liabilities were inflows or outflows of cash.
15 The company could have invested heavily in non-current assets.
The company could have repaid loan finance during the year.
The company could have paid a substantial dividend out of retained earnings or have
conducted a share repurchase.
The company could have invested heavily in current assets, such as inventory or trade
receivables.
Page 3
The profit could be based partly on transactions that do not have a cash effect. For
example, a long term contract could have led to the recognition of profit even though
the related cash payment might not be until some time in the future.
This question was answered reasonably well.
16 Balance sheets reflect two aspects of the business: the assets controlled by it and the
manner in which those assets have been acquired. This means that the assets are
mirrored by capital and liabilities and this yields the balance sheet equation (assets =
capital + liabilities). The accounting system keeps track of the various components of
assets, liabilities and capital so that this relationship is maintained.
The dual aspect concept suggests that every transaction will affect two balances.
Every entry in the books has a corresponding entry which has the effect of
maintaining the balance between assets, liabilities and capital.
The balance sheet is part of the output of the double entry bookkeeping system. This
records adjustments and transactions in such a way that any resulting balance sheet
must balance. Every entry is recorded in two places, to reflect the fact that both sides
of the balance sheet equation must hold true.
The balance sheet is also prepared on the basis of a series of accounting concepts
which means that items are only recorded in response to an event such as a transaction
or an adjustment. This means that the only assets that are listed have automatically
been reflected in the capital and liabilities accounts.
This question was answered very poorly. Most candidates struggled to come up with
more than two points. Very few candidates mentioned double entry bookkeeping or
accounting concepts, which meant they were struggling to come up with any sensible
answer. This is an area where candidates would benefit from some revision before
the next attempt.
17 The going concern assumption effectively permits accountants to prepare financial

statements that make no overt attempt to inform certain potential decisions. For
example, non-current assets are recorded at a carrying value that may bear very little
relevance to decisions such as whether the assets should be sold for their market
values. This is because the going concern assumption takes it for granted that the
assets cannot be sold because the business needs the assets in order to carry on. The
assumption also means that potential errors in short to medium term forecasts and
estimates can be tolerated because the figures will resolve themselves over time. For
example, the inventory is valued on the basis of certain assumptions about its eventual
selling price. Any error might affect the calculation of profit for the current year, but
that will be reflected by a corresponding increase or decrease in the following year
and that should not matter year on year.
In the absence of a going concern assumption, assets would have to be stated at

reasonably current values. That would both complicate the preparation of the
statements and would leave the preparers and auditors more open to challenge in the
event that the values proved to be incorrect.
Page 4
This question was also very poorly answered. Very few candidates knew what this
concept meant. Most candidates just talked about solvency and the business
continuing into the future. While this was relevant there was rarely enough detail to
give candidates many marks. The area of accounting concepts is one where
candidates would benefit from revision.
18 There is no agreed definition of the term true and fair. It is absolutely mandatory that
financial statements have this quality, but the lack of a definition means that it cannot
be measured. The various rules and regulations that deal with specific figures and
adjustments provide some guidance, but compliance may not be sufficient in itself.
Indeed, there could be circumstances in which compliance with a specific rule would
be misleading and the preparers would be required to set this aside in the interests of
giving a true and fair view.
The lack of a clear benchmark means that the truth and fairness of the set of
statements may be challenged. Accounts that have been prepared in good faith may
be portrayed as misleading by a decision-maker who feels that s/he has been misled
into making a loss.
This question was answered reasonably, however more depth would have improved
the answers.
19 (i) A company’s market capitalisation is a function of the future expected cash

flows, discounted to take account of the time value of money and risk.
Entering into a positive NPV project has the effect of creating the expectation
of additional future cash flows and these have already been adjusted for the
cost of capital.
The stock market might be viewed as a system that has an incentive to process
information about future cash flows as effectively and as quickly as possible.
Market participants who can spot future gains before their competitors can buy
before the market price catches up with any new disclosures. When it does the
share price will rise and they will have a capital gain. Any bias or error on the
part of speculators will prove expensive because they will suffer losses if the
share price falls after they buy or if any increase is too small to cover the
transaction costs.
The NPV decision rule effectively requires management to consider proposals

on the basis of their effect on shareholder wealth. If management make
correct decisions then shareholders’ wealth will increase, as reflected in
market capitalisation.
(ii) It is highly unlikely that the directors’ disclosures would enable the stock
market to calculate the NPV accurately. Apart from anything else, this would
lead to the publication of commercially sensitive information.
Market participants do not actually value shares on the basis of formal NPV
calculations. Share prices are set by a process of supply and demand, with
Page 5
most participants taking note of the buying and selling decisions of other
participants. The relationship between future cash flows and share prices is
sound, but it is more of a long-term benchmark for prices than a measure that
can be reported and valued on a day to day basis. The markets might even
take the view that companies will invest in positive NPV projects as a matter
of course and so share prices might reflect the possibility of such
announcements, even though they have yet to be made.
The markets may not wholly agree with the directors’ opinion of a project.
The directors might be deemed to have an incentive to claim optimism that is
subsequently shown to be unfounded.
(iii) Agency theory suggests that agency costs will eventually be passed on to the
directors in the form of lower salaries or a deflated share price. Information
asymmetry (the fact that directors know more about the running of the
business) is one factor in creating agency costs. Publishing information
enables the directors to signal that their stewardship of the company is sound
and that the shareholders should not be concerned.
Companies are often keen to keep shareholders informed in order to

distinguish themselves from less efficient businesses. Without information,
shareholders have no way of distinguishing well run companies with poor
prospects from those that are better. Voluntary disclosures should enhance the
share price and reduce the risk of a takeover bid motivated by the possibility
that the shares are undervalued.
This question was very poorly answered. This topic has been examined in a
similar fashion for several years now, it is difficult to know why it was badly
done on this occasion. All sections of the question were poor. The answers
lacked any depth.
Again this topic should be revised in detail before the next attempt.
1,200 + 300
20 (i) Gearing = = 58%
1,400 + 1,200
350
Current ratio = = 1.4:1
120 + 100 + 30
350 − 200
Quick ratio = = 0.6:1
120 + 100 + 30
(ii) Cash Ltd’s gearing is much higher than the industry average. That means that
the total risks are much higher. The most obvious reason for this is that the
company must meet the interest payments and loan repayments every year. If
the company has a problem with its cash flows then it will struggle to pay its
debts when they fall due. The fixed interest and preference dividend
Page 6
commitments will also make the earnings per share more volatile. That means
that the ordinary shareholders will suffer a riskier pattern of dividends.
The liquidity ratios are lower than the industry average. That is a further
reason for the risk to be higher. If the company’s current assets are
insufficient in comparison to current liabilities then the company may struggle
to pay its debts when they fall due. That could lead to the company operating
inefficiently and therefore with greater chance of errors and could make the
business more volatile.
The composition of the assets and liabilities complicates this analysis further.
The company’s bank account is overdrawn. That means that the liquidity ratio
is further cause for concern because the bank might suddenly stop the
company from writing cheques. The overdraft makes it more difficult to
manage the weak liquidity position. On the other hand, a significant current
liability is in the form of a tax liability. The company has several months to
pay this from the balance sheet date. That is a partial source of comfort
because the directors can treat dealing with that payment as a separate exercise
for which they have time to plan and prepare.
(iii) The bank does not wish to risk the company going into default on any loans.
Even if the bank loan is secured on assets or the bank has a floating charge it
is undesirable to have the loan default and have to pay the costs associated
with foreclosing. This will also create adverse publicity for the bank.
The bank might not have security and could rank alongside other creditors in
the event of default. The loan covenant will ensure that the bank’s claim to
the company’s assets is not unduly affected by a disproportionate claim from
other lenders.
The covenant will also give the bank some protection in the event that the
company starts to decline. If there are large losses or asset write-offs then the
covenant might be breached and the bank will be able to claim its money back
before the company’s cash flows give it the right to demand immediate
repayment
This question was very poorly answered. Ratio questions appear frequently in
this paper so candidates who were well prepared should have had little
difficulty with this question. It calls for understanding of the figures and
interpretation of a set of financial statements. Part 3 was poor, this was a
straightforward question, very few candidates discussed the loan covenant,
which was surprising. As this topic tends to be examined frequently some
revision is recommended.
Page 7
EXAMINATION

Core Technical
booklet.
supervisor.
question paper.
CT2 S2007 © Institute of Actuaries
correct.
1 A company has a low current ratio. Which of the following would best explain why
this is not a matter for concern?
A Shareholders are only ever interested in profit.

B The current ratio has been high in previous years.
C The company has a good credit rating.
D The company’s current ratio has always been low.
[2]
2 Which of the following would explain the need to publish a figure for diluted earnings
per share?
A There is an active market in traded options on the company’s shares.

B The company has convertible loan stock in issue.
C The company’s profit is declining.
D The company made a rights issue during the year.
[2]
3 A company’s operating profit was £2.5m. Interest paid was £0.3m. Tax was £0.6m.
Dividends paid were £1.4m. The company is financed by £10.0m of ordinary shares,
£12.4m of reserves and £5.0m of long term loans. To calculate return on capital
employed using £27.4m as the figure for capital employed, what figure would be used
for return?
A £0.8m
B £2.2m
C £2.5m
D £2.8m
[2]
4 Which of the following best explains the need to depreciate buildings, even though
their market value may be rising year on year?
A Depreciation is an accounting concept.

B Buildings have finite useful lives.
C Historically, buildings have always been depreciated.
D The depreciation charge is part of the cost structure.
[2]
CT2 S2007—2
5 Which of the following explains why insurance companies’ financial statements are
normally produced in a conservative way?
A Insurance companies are naturally conservative institutions.

B The underlying liabilities are generally both long term and difficult to predict.
C The asset base is composed largely of long term investments.
D The tax liability is reduced if profit is depressed.
[2]
6 A holding company has a 60% shareholding in a subsidiary. If the subsidiary fails,

which of the following would be a valid reason for the holding company to pay the
subsidiary’s creditors the amounts owed to them?
A Action by the subsidiary’s minority shareholders.

B Avoid adverse publicity for the group.
C The holding company is legally obliged to pay.
D Holding companies routinely guarantee all their subsidiaries’ debts.
[2]
7 A company has a very high gross profit margin. Which of the following is the only
statement which is definitely true?
A The company has a low cost-base.

B The company is over-pricing its sales.
C The company is highly profitable.
D The company makes a large percentage profit from a typical sale.
[2]
8 A shareholder owns 5,000 ordinary shares of 25p, of which 20p per share has been
paid. The shares were originally issued at a premium of 15p per share. The company
has just gone into liquidation. What is the maximum amount the shareholder would
have to pay towards the company’s liabilities?
A £250
B £1,000
C £1,250
D £2,000
[2]
CT2 S2007—3 PLEASE TURN OVER

9 Investment analysts often base their analysis of profitability on earnings before
interest, taxation, depreciation and amortisation (EBITDA). Which of the following
is NOT a valid reason for using EBITDA in preference to net profit?
A It gives an insight into cash generated from operations.

B It is more objective than net profit.
C It gives a clearer insight into future net profit.
D It is more difficult to manipulate than net profit.
[2]
10 A trade creditor is owed £6,000 by a company that is in the process of being

liquidated. The company was financed by £1m of ordinary shares, £2m of preference
shares, £2.5m of retained earnings, £0.6m of secured debentures and £3.7m of other
loans, including the trade creditor’s balance.
The creditor hopes to recover 20% of the amount owed. How much would the
company’s assets have to realise in order for this to happen?
A £0.86m
B £1.34m
C £3.34m
D £4.34m
[2]
11 Explain the difference between systematic and specific risk from the perspective of an
investor who has a portfolio of investments. [5]
12 A company wishes to rely heavily on retained earnings in order to finance a long-term

planned expansion.
Describe the problems that such a proposal might create. [5]
13 Explain why strict adherence to historical cost accounting might produce misleading
figures in financial statements. [5]
14 Gamma plc is in the process of making a rights issue. The company presently has 2m
shares in issue. The current market price is £3.00 per share. The terms of the issue
give each shareholder the right to buy one new share for every five previously held.
Each new share will cost £2.40.
(a) Calculate the theoretical price after the rights issue; and
(b) Explain why the actual price might vary from that calculated in (a).
[5]
CT2 S2007—4
15 (a) Explain why relatively new companies occasionally give warrants as an
incentive to buy shares; and
(b) Describe the main problems associated with issuing warrants.

[5]
16 An actuary has his own actuarial consultancy. He is considering taking on a business

partner.
Explain the potential advantages and disadvantages to the actuary of admitting a

partner to his business.
[5]
17 It has been suggested that quoted companies are subject to the “discipline” of
financial markets and that company managers may be penalised if they do not
maintain the markets’ support.
Explain how these disciplinary processes might operate in practice. [5]
18 An individual taxpayer, subject to UK tax law, has complained to you that she is
effectively being taxed several times on the same earnings. Her only assets are
investments in shares and also a pension scheme. These assets were purchased out of
her earned income, on which she has paid income tax. Now she feels that she is being
taxed for a second time on the returns from her investments.
Explain whether this taxpayer’s concerns are justified. [5]

19 A firm of actuaries is considering a major international expansion. They are
considering investing heavily in a feasibility study in order to determine whether to
open a major new office in a new country. There are many factors that would
determine the success or otherwise of this. For example:
• It may prove difficult to recruit suitable actuaries and support staff for the office
without offering very substantial salaries.
• It is difficult to predict how competing firms who are already established in that
country will respond to the competition.
• The new host country’s currency is very volatile compared with the firm’s home
currency and all profits from the new office would be earned in that host currency.
The feasibility study is a very costly undertaking in itself and so the firm is
considering the respective merits of three options:
• Conduct a feasibility study, prior to making a decision as to whether to proceed.

• Proceed with the expansion without first undertaking a feasibility study.
• Abandon the whole idea of the expansion.
One of the directors of the firm has prepared a probability tree using the following
assumptions:
• If the expansion goes ahead it will yield either of the following outcomes: Success
[with a positive net present value (NPV) of £5m] and Failure [with a negative
NPV of £1m].
• The feasibility study will cost £100,000 and will have an 80% probability of
correctly predicting the outcome of the expansion.
• There is a 70% probability that the feasibility study will indicate that the
expansion will succeed and a 30% probability that it will indicate failure.
• If the expansion proceeds without the feasibility study then it has a 62%
probability of success and a 38% probability of failure.
CT2 S2007—6
These assumptions yielded the following probability tree:
Success +£5m
0.8
+£3.6m
0.2
Yes Failure -£2m
Expand
+£3.6m
No
Indicate success 0.7 0

Success +£5m
0.2
+£2.52m
-£0.6m
Indicate failure 0.3 0.8
Yes
Yes - Cost £0.1m Expand Failure -£2m
0
No
Conduct
feasibility study 0
+£2.42m
Success +£5m
No - Cost 0
0.62
+£2.34m
Expand Yes
0.38
+£2.34m
No Failure -£2m
0
The director who prepared this diagram claims that it indicates that the expansion is
likely to prove successful, but that the firm should undertake the feasibility study
nevertheless.
Another director has prepared a simulation of the investment and has simulated the
outcome of proceeding for 10,000 cycles. This suggests that the expected net present
value of the expansion is negative, whether the feasibility study is conducted or not.
(i) Explain why the probability tree suggests that the firm should conduct the
feasibility study, even though the expansion is likely to be a success. [3]
(ii) Explain when it might be appropriate to use a probability tree in the evaluation
of a capital investment project. [4]
(iii) Explain why the other director’s simulation exercise may be more reliable
than the probability tree. [5]
(iv) Describe the prerequisites of a “successful” simulation of a capital investment
project. [4]
(v) It has been suggested that managers often use capital investment appraisal
techniques in order to justify decisions that they have already taken.
State, with reasons, whether or not you agree with this suggestion. [4]
[Total 20]

20 The following balances have been extracted from the books of CKL plc, as at
31 August 2007:
£000
Advertising 400
Cash at bank 16
Directors’ remuneration 170
Dividend paid 300
Interest on long term loans 18
Inventory at 31 August 2007 420
Investments (long term) 900
Long term loans 800
Materials and other manufacturing costs 1,420
Ordinary share capital, issued and fully paid 1,800
Plant and machinery – cost 500
Plant and machinery – depreciation at 31 August 2006 190
Premises – cost 2,400
Premises – depreciation at 31 August 2006 30
Repairs to manufacturing equipment 190
Retained earnings at 31 August 2006 748
Sales 4,400
Trade payables 114
Wages and salaries – administrative staff 220
Wages and salaries – manufacturing staff 800
Wages and salaries – sales staff 110
1. Premises are to be depreciated at the rate of 2% per annum on cost and plant and
machinery at 25% per annum reducing balance.
2. Corporation tax based on the year’s profit is estimated at £50,000.
(i) Prepare CKL plc’s income statement and statement of changes in equity for
the year to 31 August 2007, and a balance sheet at that date. These should
comply with Companies Act presentation requirements. [15]
(ii) The directors are concerned that some of the large amount spent on repairs to
manufacturing machinery might have been classified incorrectly. They have
asked whether some of that amount should have been treated as expenditure
on fixed assets.
Explain how the cost of expenditure on repairs might be distinguished from

money spent on fixed assets. [5]
[Total 20]
END OF PAPER
CT2 S2007—8
EXAMINATION
September 2007

Core Technical
EXAMINERS’ REPORT
Introduction
M A Stocker
December 2007
Comments
Comments are given after each of the solutions that follow.
1 D
2 B
3 C
4 B
5 B
6 B
7 D
8 A
9 C
10 B
Questions 1–10 were generally done well by most candidates.
11 Specific risk is the risk that is directly related to the investment itself . For example,
the company might have to recall a product and incur substantial costs as a result.
Systematic risks are those that are shared to a greater or lesser extent by all
companies. For example, global economic cycles means that all companies are subject
to occasional slumps. Investors need not be concerned with specific risk because
those risks can be cancelled through diversification. Provided the investors have a
diversified portfolio, their risk is related to the systematic risks of the individual
investments.
This question was done very well by most candidates.
12 There is no guarantee that the necessary surpluses will be generated in time to meet
the company’s needs. This could interfere with the efficient implementation of the
investment programme. A series of losses could even restrict the very expansion that
is necessary to return the company to profit.
The use of retained profits could interfere with the company’s ability to pay
dividends. Shareholders tend to have particular preferences for either dividends or
capital gains. Suspending a dividend to fund growth could lead to the sale of shares
and the reduction of the share price.
Retained earnings have the same cost as ordinary shares. That makes this an
expensive form of finance in comparison with debt.
It was really good to see so many excellent answers to this question. Well done!
Page 2
13 The figures in the balance sheet can be a combination of historical £ amounts from
different dates when the purchasing powers were all different. The total might not be
particularly meaningful if the assets are relatively old.
The figures in the income statement relate current selling prices to historical costs of
inventory and depreciation. This can have the effect of overstating profits when prices
are rising.
The historical cost of an asset is unlikely to be directly relevant to any decision, unless
it happens to be a reasonable approximation for another value. For example, it is
useful to know how much a piece of inventory would cost to replace before deciding a
selling price. Its historical cost might give a rough approximation, but not necessarily
This question was also answered well. However some candidates went on to discuss
depreciation methods in detail which was not required.
2m
(2m × 3.00) + ( × 2.40)
14 Price after issue = 5 = £2.90
2m
2m +
5
The actual price will depend on the market’s expectations concerning the use to which
the investment will be put. If the market feels that the directors have been unduly
optimistic then the theoretical price might not be realised. The theoretical price also
does not take into account the associated costs of the issue
This question was extremely well done by most candidates.
Page 3
15 Warrants are financial instruments that give the holder the right to buy additional
shares at a fixed price by some future date. The holder of a warrant can participate in
any subsequent growth in the share price, particularly if the warrant has a long lead
time and gives the company the opportunity to raise further funds and grow over time.
The terms of the warrant can give additional shares to the original buyer (or even be
restricted to shareholders who hold their original share allocations). That gives
shareholders an incentive to stay with the company.
Warrants can be a relatively inexpensive means of offering an incentive to potential

investors, particularly in the case of an established business that is trying to raise fresh
finance without giving up too much control.
The main problem with warrants is that they can lead to the dilution of shareholders’
rights if they are exercised in the future. That might deter some shareholders from
investing in the company once it is well established. Certainly the threat of dilution
will reduce the price at which new shares can be issued .
This question was answered reasonably by many candidates but very poorly by others. Some
revision of this topic is required.
16 Admitting a partner may require the introduction of further long-term finance into the
business. That could either fund expansion or give the owner the opportunity to
realise some of his investment
A partner will have an incentive to make the business a success. A new employee
could be just as talented, but will have less to gain from the success of the business .
The owner will have to surrender outright control of the business to give the partner
some say in its management.
The owner will be jointly and severally liable for the liabilities of the partnership.
Anything that the new partner commits the partnership to will be the personal
responsibility of both partners
This question was answered extremely well by many candidates.
17 Stock markets exist to process information as effectively and with as little bias as
possible. Share prices must reflect the market’s expectations of future cash flows or
the shares will be mispriced and investors who realise that will be able to buy or sell
at advantageous prices. This creates a situation where the directors must work towards
running things so that they create as much wealth as possible on behalf of their
shareholders. If they do not then the share price will fall and that could lead to them
being threatened with a takeover bid. In that case the directors may be replaced by a
new board appointed by the victors.
Page 4
Markets also operate in the provision of debt. A great deal of effort goes into forming
an opinion on corporate credit ratings. Companies which have poor ratings will have
to pay more for their debt, with consequences for profit and share price .
This question was answered very well.
18 Firstly, income from certain investments such as Personal Equity Plans (PEPs) or
Individual Savings Accounts (ISAs) is tax free .
Dividends from companies are effectively paid net of basic rate tax. This is not
immediately obvious from an individual’s tax return because the gross income has to
be declared, but the resulting tax is offset by the deduction. This “tax credit” is
designed to compensate for the fact that the company has paid corporation tax on the
profits from which the dividend is paid. It could, however, be insufficient to cover any
additional tax due because the taxpayer is subject to higher rates of income tax .
The taxpayer would have received some tax relief on the contributions paid into the
pension scheme. That means that the subsequent taxation of benefits paid is actually
the first time that the taxpayer has been taxed on that .
This question was done well by most candidates.
19 (i) The expected gain is higher from the branch for the feasibility study because
the probability tree makes it clear that the project should be abandoned if the
feasibility study suggests failure. This suggests that the additional information
about the risks associated with proceeding outweigh the cost of the study. If
the company would carry on with the investment even if the feasibility study
indicated otherwise then it would be better not to conduct it because that
would be a waste of money, unless the study was likely to yield information
that would somehow enhance the probability of the project’s success.
(ii) Probability trees are useful for resolving projects which involve sequential
decisions where the outcome can be changed once the project is under way.
This enables the decision maker to allow for different contingencies at the
planning stage. For example, in this example the company must decide
whether or not to conduct a feasibility study. Once the study has been
undertaken the company must decide whether to proceed with the expansion .
Probability trees are best suited to circumstances where probabilities can be
estimated for different eventualities. This means that the method is best suited
to relatively simple chains of decisions.
(iii) A simulation exercise can be much richer than a probability tree. It is possible
to incorporate far more variables into a simulation than to a probability tree. It
may also be possible to deal with distributions that might not be open to an
analytical solution. The simulation could allow for far more complex
probability distribution functions. It would also be possible to have more
realistic ranges of outcomes than the present “success” or “failure” dichotomy.
Page 5
A simulation will also provide an insight into the range of possible outcome
from different choices. The results can be presented as a distribution of
outcomes from each major choice open to the directors .
(iv) The project must be capable of being modelled. For example, it would have to
be possible to model the likelihood of the company recruiting suitable local
employees. The effects of each possibility will also have to be built into the
model so that, for example, the effects of the jobs market variables are
consistent with the salary variables. This might involve assuming that
managers behave rationally, but in practice human decision makers might not
take the most appropriate decisions when faced with, say, a run of bad luck .
(v) All of the decision tools for appraising capital projects require highly
subjective decisions and estimates from the decision makers. The results of the
appraisal exercise can be predetermined by biasing assumptions. Furthermore,
some decision aids have an inbuilt bias of their own (e.g. payback favours
early cash flows). This means that the choice of decision model can be just as
important as the decisions. It may not be a bad thing that these factors exist.
Arguably an instinctive assessment of a project’s viability can be as valid as a
slightly distorted impression from a supposedly objective model.
This question was answered poorly by many candidates. Most just wrote everything they
knew about simulations and probability trees.
The marks for this question were very poor compared to the rest of the paper. Some revision
of this topic is required by many candidates.
The main problem was that candidates simply did not answer the question.
Page 6
20 (i)
CKL plc
Income statement
£000 £000
Sales 4,400
Gross profit 1,865
Administration (390)
Distribution (510)
(900)
Interest (18)
Net profit before tax 22
987
Tax (50)
Net profit after tax 937
CKL plc
Statement of changes in equity
Retained
profit
£000
Opening balance 748
Net profit for year 937
Dividend (300)
Closing balance 1,385
CKL plc
Balance Sheet as at 31 August 2007
£000 £000
Non-current Assets
Tangible 2,555
Investments 900
3,455
Current Assets
Inventory 420
Bank 16
694
4,149
Page 7

Equity
Share capital 1,800
Retained earnings 1,385
3,185
Long term loans 800
Current liabilities
Trade payables 114
Tax payable 50
164
4,149
Formats
Non-current assets
Cost Aggregate Net book
depreciation value
£000 £000 £000
Premises 2,400 77 2,323
Machinery 500 268 232
2,900 345 2,555
Workings
Cost of sales
Materials 1,420
Repairs 190
Wages 800
Depreciation on premises 48
Depreciation on machinery 77
2,535
Admin
Directors salaries 170
Wages 220
390
Distribution
Advertising 400
Wages 110
510
(ii) A fixed asset is something that will be held by the business and will be used to
generate income over more than one period. Any expenditure on a fixed asset
that increases its capacity to generate income should be classified as an
addition to fixed assets. For example, an extension or a modification to a
production line should be treated as a fixed asset. Repairs are essentially
Page 8
running costs of the business. A repair would have the effect of ensuring that
an asset would continue to run and generate an income. For example, the
routine servicing and lubrication of a machine would be a repair.
On the whole the first part of the question was well answered, the only really common error
was confusing the stock in the Income Statement and therefore getting an incorrect Cost of
sales figure. Some compounded this error by changing the Balance Sheet to make it balance
which then made an additional figure incorrect. The formats were generally poor. Many
students omitted part b or gave a very brief answer – few scored highly here.
Page 9
EXAMINATION
17 April 2008 (am)

Core Technical
booklet.
supervisor.
question paper.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
correct.
1 A company has a high return on capital employed but a low gross profit percentage.
Which of the following is the best interpretation of these results?
A The company is profitable because it prices its sales aggressively.
B The company should increase its selling prices.
C The company is unprofitable despite a high return on capital employed.
D Gross profit is a very straightforward measure, so the company should

disregard the return on capital employed.
[2]
2 A company has a high price earnings (P/E) ratio. Which of the following is the most
likely explanation for this?
A The current share price is too high.
B The current share price is too low.
C If the directors could increase reported earnings then the share price would be
even higher.
D The stock market is confident in the company.

[2]
3 A company’s board of directors is considering an approach by a competitor who

wishes to offer the shareholders an attractive price for their shares so that it can take
the business over. Which of the following responses is most compatible with agency
theory?
A The directors will probably recommend the acceptance of the offer because it
will maximise the shareholders’ wealth.
B The directors will probably recommend the rejection of the offer because it
would threaten their job security.
C The directors will probably recommend the rejection of the offer because they
have no desire to maximise the wealth of a competitor’s shareholders.
D The directors will probably recommend the acceptance of the offer because
the amount offered is greater than that set by market forces.
[2]
CT2 A2008—2
4 A company is planning to issue subordinated bonds. What rate of interest will have to
be offered on them relative to that on the company’s existing debt?
A zero interest
B lower than existing debt
C the same as existing debt
D higher than existing debt
[2]
5 A company has 500,000 warrants outstanding with a strike price of £2.00. The
current share price is £1.90. The warrants are about to expire. How much money is
the company likely to receive from the exercise of these warrants?
A nil
B £50,000
C £950,000
D £1,000,000
[2]
6 A project has a positive net present value when the cash flows are discounted at 10%.
The project has two internal rates of return of 8% and 15%. What is the most likely
explanation for this set of figures?
A The project should be accepted if the required rate of return is more than 8%.
B The project should be accepted if the required rate of return is more than 15%.
C The project should be accepted if the required rate of return is between 8%

and 15%.
D The project should be accepted if the required rate of return is less than 8% or
more than 15%.
[2]
7 To whom does the external auditor report?
A users of financial statements

B the shareholders
C providers of finance
D shareholders and regulatory bodies
[2]

8 A company paid £400,000 for a property. The property was depreciated at 2% of cost
each year for ten years. The directors have had the property revalued at £700,000.
How much is the gain on revaluation?
A £140,000
B £300,000
C £308,000
D £380,000
[2]
9 A company has 2,000,000 ordinary shares of £1 in issue. The current market price is
£4.00 per share. The directors are about to make a scrip issue of 500,000 shares.
What is the expected market price per share after the scrip issue?
A £0.80
B £1.00
C £3.20
D £4.00
[2]
10 A company’s debentures have a face value of £1,000 and a market price of £900.
Which of the following is NOT a potentially valid explanation for this difference?
A The debentures are close to redemption.
B The markets lack confidence in the company.
C The interest rates available on similar instruments are higher than the
debenture coupon rate.
D The debentures were issued at a discount with an artificially low coupon rate.
[2]
11 Explain the advantages and disadvantages of showing properties at their current

valuation rather than at cost less depreciation. [5]
12 Explain why financial statements must be supplemented and supported by notes to the
accounts. [5]
13 Explain the purpose of accounting standards. [5]
CT2 A2008—4
14 A company wishes to raise additional finance but it has been prevented from
borrowing by the conditions imposed by an existing loan agreement.
Explain why a lender might impose such a restriction before granting a loan. [5]
15 A company’s board of directors is revising the company’s investment appraisal

criteria. The directors have asked for an explanation of the concept of opportunity
cost and the manner in which it might impact on the selection of projects.
Outline the points you would make. [5]
16 A company is planning to raise additional funds by issuing shares.
Describe the advantages of doing so by means of a rights issue. [5]
17 Explain why shareholders might be worried because a quoted company’s diluted

earnings per share is significantly lower than its basic earnings per share. [5]
18 (a) Explain what is meant by the term “subsidiary company”.
(b) Explain why a holding company is required to prepare a set of consolidated

financial statements for its shareholders.
[5]
19 A major quoted company has had a policy of reinvesting earnings and paying very
little in the way of dividends for many years. The company now finds itself with a
significant cash balance and very few attractive projects in which to invest. The
directors are debating the merits of paying a substantial dividend.
(i) Explain why the potential tax implications of receiving a dividend might make
this proposal unpopular with this company’s shareholders. [8]
(ii) Explain why it might not be viable for the company to simply retain the funds
and to wait until some attractive investment opportunities arose. [8]
(iii) Explain why a quoted company might choose to release commercially

sensitive information about investments and performance to the financial
markets. [4]
[Total 20]

20 The latest balance sheet of Rough Ltd is as follows:
Rough Ltd
Balance sheet as at 31 March 2008
£m £m
ASSETS
Non-current assets
Intangible 8
Property, plant and equipment 7
15
Current assets
Inventory 2
Trade receivables 3
5
Total assets 20

Share capital 4
Retained earnings 6
10
Secured loans 7
Current liabilities
Trade payables 2
Bank 1
3
20
Vest Ltd supplies raw materials to Rough Ltd. The finance director of Vest has just
discovered that Rough has run into serious problems and is likely to be wound up.
This is a matter of major concern because Rough owes Vest £500,000 which is
included in the trade payables as at the latest balance sheet date.
The finance director of Vest is trying to estimate how much, if anything, the company
will receive once Rough has been wound up. The following information has been
gathered from various sources:
• Intangible non-current assets comprise the cost of buying a licence to manufacture

a product that has been the cause of Rough’s downfall. The product has been
linked to a major consumer safety scare.
• Property, plant and equipment has been offered for sale and is likely to realise
£6m.
• Inventory and trade receivables are likely to realise 50% of their book values.
CT2 A2008—6
The chief executive of Vest has suggested that it might be worth considering buying
Rough as a going concern. It would cost approximately £8.5m to acquire and
reorganise the company so that it could manufacture a new product range that would
make heavy use of Vest’s materials. This new line of business is expected to generate
a net annual cash flow of £0.8m in perpetuity.
Vest’s cost of capital is 8%. Enquiries of the directors of Rough suggest that their
cost of capital prior to the collapse was 11%.
(i) Calculate the amount that Vest is likely to receive from Rough in the event
that the company is wound up. [5]
(ii) (a) Calculate the value of Rough to Vest, assuming required rates of return
of 8% and 11% on the estimated future cash flows.
(b) Comment on your findings in (a).

[3]
(iii) (a) Explain why the appropriate required rate of return for this investment
is unlikely to be that of either Rough or Vest.
(b) Explain how Vest should go about valuing the proposed investment in
Rough.
[12]
[Total 20]
END OF PAPER
CT2 A2008—7

Core Technical
EXAMINERS’ REPORT
April 2008
Introduction
M A Stocker
June 2008
Comments
There were some excellent marks achieved on this paper; well done to all those candidates
who scored high marks. It was however disappointing that the pass rate was poor compared
to the last diet. There were also some very poor scripts at the bottom of the spectrum.
Candidates generally achieve high marks in the questions where knowledge is the main
requirement; it is however disappointing to note that where application of knowledge is
required there are some very poor answers.
As usual, in this exam, it is the two long questions at the end where some candidates get very
low marks.
It is very beneficial to practise past exam questions and I would recommend that all
candidates try to complete past papers within the time constraints required when revising.
Comments on individual questions are given after each of the solutions that follow.
1 A
2 D
3 B
4 D
5 A
6 C
7 B
8 D
9 C
10 A
Comments: Generally Q1–10 were done very well. Many candidates scored full marks.
This was gratifying, as the marks for the MCQs were fairly poor for the previous two diets.
11 Advantages:
The balance sheet will better reflect the underlying worth of the company’s assets .
This will enable shareholders to have a better appreciation of management’s
stewardship (because there is a more realistic measure of the value of the assets
entrusted to them) . Lenders will have a better understanding of the value of assets
being pledged as collateral. It fits in with more recent emphasis on ‘fair value’.
Disadvantages:
Valuations will always be more subjective than stating figures at cost less
depreciation. There will be costs, such as valuers’ fees, associated with showing
valuations. Values are likely to be more volatile than cost less depreciation and the
associated fluctuations might make the business appear more risky.
Comments: This question was done very well by most candidates. It was good to see
such good answers to this question.
12 The notes provide additional detail concerning the underlying figures. These analyses
will provide the shareholders with a better understanding.
Notes might deal with qualitative matters and disclosures that could not be reflected
in the financial statements. For example, descriptions of contingent liabilities could be
vitally important.
Many of the disclosures in the notes are required by law. The rules and regulations
associated with accounting effectively require the publication of notes to the accounts.
Providing an overview in the main statements and supplementing that with the notes
gives shareholders and other readers the choice of reading further if they wish. Expert
readers can consult the notes while non-experts can stick to the statements
themselves.
Page 2
Subject CT2 (Finance and Financial Reporting Core Technical) — April 2008 — Marking Schedule
Notes and appendices avoid burdening the income statement and balance sheet with
excessive information.
Comments: This question was done well by many candidates. Few candidates
mentioned that many of the notes are statutory requirements or that qualitative
matters could be discussed by note and this would be very informative for users of
financial statements.
On the whole there were some very good answers for this question which was good to
see.
13 Accounting standards provide a basis for consistent treatment between companies.

They are the accountancy profession’s response to inconsistent treatment or to
accounting practices that are controversial or potentially misleading.
Accounting standards provide companies with a benchmark against which to measure
the validity of their accounting policies and to demonstrate that their accounts give a
“true and fair” view. That may reduce agency costs due to shareholders and other
readers being concerned that the accounting policies in force are incorrect. The fact
that financial statements are supported in this way should enhance shareholder
confidence in the resulting figures and so the share price should be higher.
The publication of accounting standards also enhances the accountancy profession’s
reputation. The resources invested in the process provide proof that the profession is
taking its responsibilities seriously and provide a mechanism for debating important
issues.
Comments: There were a few very good answers to this question but on the whole it
was poorer than expected. The answers were very short and lacked any detail.
14 Further loans might rank alongside or even ahead of the existing lender’s rights in the
event of liquidation. Barring the borrower from taking out further loans will reduce
the risk of assets being diluted in the event of a foreclosure or claim. The payment of
additional interest will have an impact on cash flows.
The additional debt might increase the risk of the company failing. Even if that does
not directly threaten the existing lender’s rights, the lender would rather have its
customers survive and repay their debts on time.
If the company cannot raise fresh funds from borrowing then it will have to raise
equity. Equity provides a “buffer” between the value of assets and liabilities and the
higher the equity the safer all lenders’ positions become.
Comments: This question was done reasonably well. Most candidates mentioned the
possibility of the company failing and of raising capital by equity rather than debt if
they could not raise a loan.
Page 3
15 Opportunity cost is the cost of passing up the next best choice when making a
decision. If a company has mutually exclusive projects then the opportunity cost of
accepting one project is that it will be impossible to accept any of the others. For
example, building a bridge with an NPV of £1m might mean that there is no real point
in building a tunnel which would have an NPV of £1.5m if built on its own.
Companies might also face capital rationing. Accepting a positive NPV project might
involve using funds that could be applied more profitably elsewhere.
Considering opportunity costs complicates the investment appraisal process because
of the need to determine the NPV of competing projects. However, it may be difficult
to spot opportunities that have been missed or overlooked and so there may be very
little risk of criticism arising from a missed opportunity.
Comments: This was a fairly standard question and was done well by most
candidates.
16 Rights issues are less complicated than making an issue to members of the public.
There are fewer regulatory requirements to be dealt with and the company can
therefore pay less in fees and other costs. There may be less need to underwrite the
issue. This may make rights issues more cost-effective for dealing with smaller
amounts of equity.
Rights issues simplify the issues associated with setting prices. Any discount will be
enjoyed by existing shareholders. This will avoid diluting the equity of existing
shareholders if the shares are issued at a discount.
Comments: This type of question has been asked many times in previous diets, it was
therefore very disappointing to see so many poor answers. While many candidates
could mention the basic points few achieved a high mark.
17 The basic earnings per share reflects both the earnings for the most recent year and
the number of shares with a right to participate in those earnings. Ultimately, the
shares only have value because earnings create the potential for the company to pay
dividends and generate cash for the shareholders.
The diluted earnings per share adjusts for the potential effects of converting or
exercising any instruments in issue that give their holders the right to obtain ordinary
shares. If there is a large quantity of such instruments in issue then there is the
potential for a major dilution of the earnings enjoyed by existing shareholders.
Conversion will normally involve an inflow of cash, and eliminate some other
outgoings, such as interest on a convertible bond, but the gains from doing so are
unlikely to fully compensate for the larger number of shares in issue. Apart from
anything else, the rights associated with such instruments have to be attractive to
buyers or they will have to be offered at a lower price.
Comments: This question was not very well done. Some candidates wrote very short
answers for this. Many candidates were unsure what diluted earnings per share
meant and gave poor answers to this. This is an area of the syllabus that candidates
should revise for the next attempt.
Page 4
18 (a) A subsidiary is a company that falls under the control of a holding company.
This normally happens through ownership of a majority of shares carrying
voting rights, but there is no need to own any shares in order to create this
relationship.
(b) Consolidated financial statements are necessary in order to show the holding
company shareholders how their wealth is being invested. The group is an
economic entity. The financial statements of the individual companies give no
real insight into the performance of the group as a whole.
A consolidated balance sheet is required to avoid the group from misreporting

the resources available to the directors and the associated liabilities that have
been used to finance their acquisition. Internal relationships need to be
identified and cancelled.
Comments: This question was answered well by many candidates. Part (a) was well
done but part (b) less so. Again some revision of this area of the syllabus would be
useful before the next attempt. This question was straightforward and very high marks
should have been achieved by candidates.
19 (i) Generally, shareholders who have significant taxed income from other sources
prefer that companies do not pay dividends. This is because the additional
income from the dividend will be taxed at the taxpayer’s highest rate.
In theory, if a company reinvests profits rather than paying them out in

dividends then the value of shares should increase, and the shareholders will
then receive a capital gain equivalent to the dividend that has been foregone.
Thus, pre-tax, shareholders are indifferent between dividends and capital gains
However, the tax treatment of capital gains is different for a number of
reasons. Firstly, the taxpayer will probably have a separate annual allowance
for capital gains. Secondly, the marginal rate of tax paid on capital gains may
be lower than that on income. Thirdly, the tax payable on capital gains can be
deferred by retaining the shares and selling only when it is deemed
advantageous to do so. Tax on income has to be paid almost immediately, with
no real opportunity to manage this.
Companies that have known and predictable dividend policies are likely to
attract shareholders with a particular preference for income versus capital
gains. If the company switches from one approach to the other without giving
substantial warning then shareholders could be disadvantaged.
(ii) The basic accounting equation is Assets = Capital + Liabilities. Every asset
has to be financed by either equity or borrowing and every source of finance
carries a cost. Holding assets that do not yield any return means that the
company is incurring a cost of capital for nothing .
The shareholders will view a “wait and see” policy as a low return on their
equity. The directors have a responsibility to maximise the owners’ wealth. If
they cannot offer a realistic return on cash holdings then they should give the
Page 5
funds back to the shareholders. To do otherwise imposes an opportunity cost

in terms of delaying consumption or in terms of leaving shareholders unable to
invest elsewhere to greater effect.
There are also market forces at work . A substantial cash balance would make
the company attractive to a predator. The directors’ apparent inefficiency
would make such a bid more attractive. These disciplinary forces are one of
the most powerful motivators to ensure that the directors focus on the
company’s profitability.
(iii) The directors face a dilemma when deciding what information to release.
Competitors will use anything that they release to gain an advantage.
However, withholding information will create uncertainty in the minds of
shareholders (the agency costs of information asymmetry). That uncertainty
will translate into a reluctance to trust the directors and so share prices will fall
and loan agreements will become more difficult to complete. That will push
up the cost of capital.
In theory, keeping the markets informed should protect the company from
some of the disciplinary forces that might threaten the directors’ positions.
Comments: This question was generally done badly. Part (i) was poor; although
candidates could mention how capital gains were taxed that was really all that was
said. It was disappointing that few candidates mentioned anything about the
advantages of companies with a steady dividend policy.
Part (ii) was also very poor with many candidates giving very short answers. Very
few candidates seemed to understand that holding assets that do not create any return
was a poor idea.
Part (iii) was also poor. A number of candidates did not answer this at all and others
gave very short answers along the lines of “information is important”. This was not
rewarded. It was disappointing that few candidates had thought about this issue.
Some revision of this topic would be useful before the next attempt.
20 (i) Proceeds of winding up:
Intangible assets 0
Property, plant and equipment 6.0m
Current assets 2.5m
8.5m
Applied:
Secured loans 7.0m
Unsecured lenders 1.5m
Thus, unsecured lenders will share £1.5m in settlement of their £3m liabilities,
so they will receive 50% of the amount due. Vest will received £250,000 .
Page 6
(ii) (a) Initial outflow = £8.5m

Inflow = £0.8m in perpetuity.
At 8% this has a net present value of £0.8m/0.08 - £8.5m = £1.5m
At 11% this has a net present value of £0.8m/0.11 - £8.5m = (£1.2m)
(b) The desirability of this project depends on the discount rate that is to
be applied. Thus, it is not entirely clear cut whether it would be a good
investment.
(iii) (a) The required rate of return should be related to the risks associated
with the project itself. The proposal is going to take Vest into
completely new territory because it does not manufacture this range of
products. Thus Vest’s normal required rate of return is not appropriate.
The strategic fit of the proposal also has to be considered . There might
be synergies or inefficiencies associated with working in this way and
so the cash flows from the project ought to be looked at in conjunction
with those of Vest.
Vest’s shareholders will not necessarily share their directors’

impression of the investment. The investment could have a knock-on
effect on Vest’s share price and its overall cost of capital.
Rough’s required rate would not be appropriate, partly because the

company will be reorganised and be manufacturing a different product
and partly because the company’s collapse gives additional insights
into its risks.
(b) Ideally, Vest will be able to identify an appropriate rate by finding a

quoted company whose business is similar to that of the reorganised
Rough. That company’s cost of equity would be an ideal basis for
setting the required rate of return .
Alternatively, Vest might be able to obtain a beta coefficient for a

similar investment, thereby determining the systematic risk of the
project and setting an appropriate required rate of return.
Vest might attempt a simulation exercise for the company. Designing a

model that estimates cash flows under different situations and inputting
a range of assumptions would give some idea of the extent to which
the company is exposed to different risks. The resulting output would
give an indication of the expected distribution of outcomes that might
be expected and so the value might be more easily determined.
Comments: This was a fairly standard question and it was answered very badly.
This type of question has been asked in the past so it should not have come as a
surprise.
Part (ii) was done reasonably well but part (i) was very poor. It was very
disappointing to see many candidates doing (i) so badly. It would be an excellent idea
to look closely at past exam papers and attempt them under exam conditions before
the next attempt.
Page 7
In (iii) (a) very few candidates mentioned the possible effect on the cost of capital or
the share price. This point demonstrated understanding and was an excellent point to
make but very few candidates mentioned this.
Page 8
EXAMINATION

Core Technical
booklet.
supervisor.
question paper.
 Faculty of Actuaries
CT2 S2008  Institute of Actuaries
correct.
1 Which of the following best explains why an excessively high current ratio is
undesirable?
A the business might run out of cash

B too much cash will encourage overspending
C there is a cost associated with holding assets that do not generate a return
D too much working capital will lead to calls for higher dividends
[2]
2 Who bears the legal responsibility for the financial affairs of a limited company?
A the board of directors

B the external auditor
C the finance director
D the shareholders
[2]
3 A company’s shares are trading at 20p on the open market. The shares have a par
value of 25p. The directors wish to raise additional share capital, but have been told
that this would be impossible at the moment. Why is the company unable to issue
fresh shares?
A the company is obviously out of favour with the market

B the directors would have to offer too big a discount on the sale
C companies are not permitted to sell shares at a discount to their par value
D issuing shares when the price is depressed would dilute shareholders’ holdings
[2]
4 A company has ordinary shares and preference shares in issue. If the company is
wound up, how would the funds released from the liquidation be distributed?
A to all providers of finance in proportion to their holdings

B to lenders first, then to all shareholders
C to lenders first, then to preference shareholders, then to ordinary shareholders
D to preference shareholders, then to lenders, then to ordinary shareholders
[2]
CT2 S2008—2
5 Which of the following best describes the purpose of margin payments associated
with futures contracts?
A to ensure that there can be never be any default in a contract

B to offset the clearing house’s exposure to defaults
C to remind the parties to the contract of their potential exposure
D to keep track of gains and losses on contracts
[2]
6 A company issued 1m shares by tender. The tender offers received were as follows:
 500,000 at £1.00
 400,000 at £1.20
 250,000 at £1.30
How much would you expect this issue to raise?
A £1,000,000
B £1,155,000
C £1,200,000
D £1,300,000
[2]
7 A company wishes to raise additional funds. Which of the following is most likely to
reduce the company’s weighted average cost of capital?
A debenture stock
B ordinary shares
C preference shares
D subordinated loan stock
[2]
8 Which of the following best explains why a company might borrow cash in order to
maintain its dividend payments after a bad year?
A the company will be able to obtain tax relief on the loan interest
B shareholders with a particular set of tax circumstances are attracted to

companies that provide income rather than capital gains
C the directors are concerned with maintaining the shareholders’ wealth
D shareholders might overreact to a reduction or suspension of the dividend

payment
[2]

9 A project has a very short payback period but a negative net present value. Which of
the following best describes the action that should be taken?
A the project should be accepted
B the project should be rejected
C the project should be accepted only if the company has limited funds for
investment
D the project should be accepted only if it is necessary for some other reason,
such as meeting mandatory health and safety requirements.
[2]
10 A company has 5m ordinary shares in existence and 2m 7% convertible preference

shares. Both categories of shares have a par value of 25p. The convertible shares can
be exchanged for ordinary shares on a 1 for 1 basis. The company’s net profit was
£800,000.
What is the company’s diluted earnings per share?
A 10.9p
B 11.4p
C 15.3p
D 16.0p
[2]
11 A company’s directors are unable to decide whether to invest in a particular project.

Discuss the extent to which a simulation exercise might help them to reach a
conclusion. [5]
12 A company’s income statement shows that it has generated substantial profits but its
cash flow statement indicates that it has suffered a large outflow of cash during the
same period. The figures are reliable and free from distortion.
Explain whether this set of circumstances warrants any major concern. [5]
13 Explain why the interpretation of a company’s accounting ratios requires some

understanding of the nature of the business and the industry in which it operates. [5]
14 Explain the implications to the reader of a qualified independent auditor’s report. [5]
15 Explain the implications to the shareholders of issuing company directors with stock
options as part of their remuneration package. [5]
CT2 S2008—4
16 Explain how the tax system might actively encourage taxpayers to make provision for
their retirement. [5]
17 Three consultant actuaries have been in business, operating as a partnership, for

several years. They are considering borrowing a substantial sum in order to expand
and are considering incorporating their business as a limited company, with
themselves as both shareholders and directors.
Explain the advantages of a limited company compared with a partnership for the
three partners. [5]
18 Agency theory suggests that there is a great deal of conflict between the interests of
various stakeholders. This has led to a set of observable and significant costs
associated with monitoring and protecting individual interests. Arguably, all
stakeholders would benefit if they could agree to work together in the best interests of
the entity, without incurring these agency-based costs.
Explain why it would be difficult, if not impossible, to eliminate these agency costs.
[5]
19 An investor has a policy of investing in a diversified portfolio. He has a wide range

of investments in stocks and shares, all of which have low Beta coefficients. He is
concerned that his returns have not been as healthy as he would have liked over the
past several years and he has asked your advice on a number of issues.
 The return on his portfolio has generally been steady, but it has not been very
much better than he might have obtained from certain bank deposit accounts.
 His return suffered a major setback in 2004 in the aftermath of the tsunami in the
Indian Ocean. Investments in companies based in countries affected by the
disaster and those linked to the travel industry were badly affected by the crisis.
 He has been offered the opportunity to liquidate his portfolio and invest in a new
overseas property development in Bulgaria. The project has a very attractive
forecast return and the Beta coefficient is close to zero.
(i) Explain why the return on this investor’s portfolio is unlikely to be

particularly high. [6]
(ii) Explain why his portfolio might have taken a major setback in the aftermath of
the tsunami, despite the extent of the diversification. [6]
(iii) Explain whether it would be logical to reinvest the value of his portfolio in the
Bulgarian development. State the assumptions that you have made in giving
your advice. [8]
[Total 20]

20 Grow Ltd is a manufacturing company. The directors are meeting to discuss some
aspects of corporate strategy and also to plan for the publication of the annual report
on the current year’s trading. The following set of draft financial statements,
combining actual results to date and forecast figures for the remainder of the year, has
been presented to the directors:
Grow Ltd
Forecast income statement
for the year ended 31 December 2008
£000
Revenue 5,000
3,000
Other operating costs (500)
2,500
Finance charges (720)
Net profit 1,780
Grow Ltd
Forecast balance sheet
as at 31 December 2008
£000 £000
Current assets
Inventory 167
Bank 50
634
Total assets 18,134
Equity
Share capital 5,000

9,870
Loans 8,000
Current liabilities 264

18,134
CT2 S2008—6
The directors are considering the effects of a proposal to invest in a major new piece
of equipment that will expand the company’s capacity and will create the potential to
generate substantial new cash flows. The equipment will have to be purchased almost
immediately or the opportunity to take advantage of the potential sales will be lost.
The equipment will cost £10m. Its acquisition will be funded by a loan paying annual
interest at a rate of 9%. The company will depreciate the new equipment at 10% of
cost each year, with a full year’s depreciation charged during the year ended
31 December 2008. Two months’ interest will also be accrued on the loan. There will
be very little additional business this year because of the need to install and set up the
equipment.
The directors’ only reservation about this proposal concerns the impact that it will
have on the company’s financial statements. They are concerned that they will look
unprofitable and more risky.
(i) Recalculate Grow Ltd’s figures to show the income statement and balance
sheet as if the new equipment had been acquired on the terms stated above.
[7]
(ii) (a) Calculate the return on capital employed and gearing ratios both before
and after adjusting for the effects of the acquisition of the equipment.
(b) Comment on the results in (a).

[6]
(iii) Explain whether it is logical for the directors to allow the proposal’s impact on
the financial statements to affect their decision about proceeding with the
investment. [7]
[Total 20]
END OF PAPER
CT2 S2008—7

Core Technical
EXAMINERS’ REPORT
September 2008
Introduction
R D Muckart
November 2008
Comments
It was good to see some better results than in the previous diet.
There were some excellent papers.
As discussed above there are some areas where there could be an improvement and some
areas where revision would be sensible.
On the whole a much better performance than last time.
Comments on individual questions are given after each of the solutions that follow.
1 C
2 A
3 C
4 C
5 B
6 A
7 A
8 D
9 D
10 B
Q1–10 comments: The MCQs were done well by most candidates. There was no noticeable
problem with any question. Well done!
11 The output of a simulation will offer the directors an indication of the distribution of
expected outcomes from the project . That will also indicate the project’s sensitivity to
different factors and assumptions . The output from the simulation might reduce the
need to establish a hurdle rate in advance . Simulation may make it possible to
evaluate projects that could not otherwise be analysed analytically.
The reliability of the simulation depends on the reliability of the underlying

assumptions . If the model is specified badly then the resulting projections will be
incorrect . There is a danger that a sophisticated analysis will have more credibility
than it deserves and the directors will have undue confidence in the results .
Q11 comments: The majority of candidates could identify roughly what a simulation
was, scoring marks for a distribution of outcomes and use to test sensitivity. A
noticeable number discussed scenario testing, sensitivity analysis and monte carlo
analysis separately rather than focusing on simulation but still showed enough
understanding for two marks. Only a minority really discussed the
drawbacks/difficulties of using it. Drawbacks were generally limited to use of an
expert, cost and time constraints rather than difficulties with the input variables or
over confidence in the results.
Page 2
12 The main reason for being in business is to generate profit . A healthy profit is vital to
a company’s long-term viability . In the short term it is possible that investment and
expansion will lead to an outflow of cash. Such outflows are not dangerous in
themselves provided they are properly managed. If the company is profitable then it
will generate net cash in the very long term. That means that it should be possible to
borrow in order to deal with short-term cash crises. However, profitable companies
can collapse if they are short of cash, so the situation should be monitored.
Cash flows are important to the short-term survival of the business, but they are not
long term business objectives. A cash outflow might occur because of a deliberate
decision to put surplus funds to work in the business.
Q12 comments: Generally high marks were scored. Most started with a discussion on
accruals and realisation concepts and how cash is different to profit but went on to
discuss plausible reasons that do not cause concern and discussed the pitfalls of
running out of cash. The weaker candidates tended to list possible causes of a
difference (e.g. purchase of assets — high cash outflow now but depreciation reduces
profit over many years) without really explaining whether it was a cause for concern
i.e. did not answer the question.
There were some excellent answers for this question. Well done!
13 Ratios provide insights into the policies and strategies followed by the company. An
understanding of the business is necessary in order to make an informed decision as to
the merits of a strategy or policy. For example, a company might have a very high
gross profit percentage because it sells a premium brand. It might look as if the
company is losing sales volume because of its pricing policy, but the company may
know that its exclusivity and pricing is one of the factors that actually attracts
business.
Some businesses are forced to accept certain costs and inefficiencies because of
industry norms. For example, slow payment might be the norm in a particular
industry. It would be dangerous to press for a reduction in a debtors’ turnover ratio if
that would mean offering less attractive credit terms than the rest of the industry.
Q13 comments: It was heartening to see that this question was answered well by
many candidates. Generally good examples were provided.
Page 3
14 A qualified audit report indicates that the auditor had a specific concern or concerns
with the financial statements. This could arise because of material disagreement over
the figures and the manner of their calculation or certain types of uncertainty
concerning the audit, such as a limit on the information obtained.
Anyone reading a qualified audit report should be alerted to the auditor’s particular
concerns. The information in the audit report should be specific enough for the reader
to have a clear idea of the potential problems with the accounts. The reader might
reinterpret or restate the figures in response to any disagreement or might attach less
confidence to them because of any uncertainty.
Q14 comments: The majority of candidates identified what a qualified audit report
was and that there would be a lack of confidence (sale of shares was a common
answer). However, generally the answers went into as much detail on the other forms
of report. Many candidates discussed unqualified reports, this was not required, nor
was a discussion on types of qualification.
15 Stock options give the directors an incentive to work on improving the company’s
share price. The options will only have value if the share price exceeds the strike price
when the options reach their maturity. This should have the effect of reducing many
of the agency concerns that the shareholders might perceive. Maximising shareholder
wealth should have the effect of enhancing the value of the stock options.
If a significant number of options is issued in this way then the shareholders risk the
dilution of their equity when they are exercised. This could make the options a very
expensive form of remuneration.
Q15 comments: Most candidates did this question very well and scored high marks.
Well done!
16 The government may seek to encourage private and institutional pension

arrangements by offering tax relief (or even subsidy) on contributions and, possibly,
investment earnings within the pension scheme. The tax relief will make it
particularly attractive for individuals on higher rates of tax to invest in a pension plan.
The relief offered to the schemes themselves makes it easier to build up a solid asset
base with a view to making it possible to provide better pensions in the longer term.
While the final pension benefit will be subject to tax, when paid, the individual
recipient will often benefit from a lower personal tax regime when in retirement. This
prospect makes it very tax-efficient to put off taking income during employment and
putting as much as can be afforded into a pension.
Q16 comments: Answers varied widely. Surprisingly a large number limited their
answers to tax relief on contributions and ISAs. A noticeable number took a
theoretical standpoint and discussed possible measures the government could take
e.g. increasing taxes on expenditure. This question was answered badly by many
candidates.
Page 4
17 In theory, the switch to a company will protect the personal assets of the partners.
Any claims made against them will be limited to the assets of the company itself. In
practice, that might not always work because lenders might insist that the
directors/shareholders of a small company give a personal guarantee against the
company’s assets.
It might be easier to expand in the future because the company structure will make it
easier to admit an additional owner. The new partner would have been jointly and
severally liable for the partnership’s liabilities, but would not be liable for anything as
a member of the company unless s/he signed a guarantee.
The creation of a company will also give other parties dealing with it a clearer idea of
whom they are involved with. For example, a new employee will work for the
company, which has a separate legal identity, rather than a collection of partners.
Q17 comments: This question was generally answered well but often candidates
wasted time discussing disadvantages of Ltd companies or advantages of
partnerships. Apart from that this was well answered.
18 Discretionary monitoring costs and covenanting costs could only be eliminated if the
stakeholders could trust one another. In principle, this would simply require mutual
confidence in one another’s integrity. In practice, there would always be observable
conflicts of interest and that would create room for doubt. These doubts would grow
because of information asymmetries. Concerns about attitudes and commitment
would grow because those whose behaviour and intentions were in doubt would be
the source of any assurances offered.
In reality, it can be seen that these pressures often lead to additional, non statutory
monitoring and disclosure that is designed to reduce the uncertainties arising from
information asymmetry.
Q18 comments: Candidates tended to provide examples of how different stakeholders

had differing interests in the business and their requirements and goals varied as a
result which would cause mistrust and conflict. This was an equally valid approach.
On the whole this question was answered well.
19 (i) Returns from financial investments are set by market forces. The market
rewards investors for delaying consumption and for bearing risks. Market
prices rise as risk falls, thereby correcting any excessive return for a given
level of risk. This investor is bearing relatively little risk and so his returns are
unlikely to be high. The market would offer a better return if he wished to bear
greater risk through investing in a more volatile set of securities.
Page 5
In a CAPM world, the markets restrict the return for risk to systematic risks
only. Our investor has built a portfolio with a relatively low systematic risk.
Q19 (i) comments: The majority of candidates provided CAPM equations and
explained these and generally candidates explained low risk = low return.
This question was done well by the majority of candidates.
(ii) A portfolio of low beta shares will have a relatively low volatility relative to
the market as a whole. If the average beta is 1.0 then the portfolio should
move in line with the market as a whole. If it is less than 1.0 then market
fluctuations will still work through, but they will be lower than the volatility in
the market. The investor will still bear some systematic risk.
Diversification cannot ever eliminate every risk that adversely affects all
securities to some extent. The tsunami is an example of such an event because
it affected economies and costs (e.g. of insurance coverage) and so the markets
as a whole experienced a downturn.
Our investor’s diversification is also likely to be imperfect. Dealing costs

mean that investors have to spread their capital across a restricted number of
shares, and each will be over-represented relative to the market as a whole.
Thus, a diversified investor may still have too much invested in travel
companies and be unduly affected by a disaster that affects that industry.
Q19 (ii) comments: This part of the question was done badly by many
candidates. Most candidates were struggling to give more than a brief
answer. The majority of answers were limited to mentioning that the tsunami
was a systematic risk that could not be diversified away. Marks were fairly
poor for this section.
(iii) A beta of zero means that an investment will not be affected by a movement in
the market. That means that, in theory, the investment is risk free. However,
that is only true in the context of a diversified portfolio. Our investor will have
full exposure to all of the specific risks associated with this development.
If the project has an attractive forecast return then it is reasonable to expect the
associated risks to be equally high. Otherwise, there would be so much
competition to buy property on the development that supply and demand
would push prices up and potential returns down.
Our investor appears to have a low appetite for risk. This is a risky investment
and so probably will not appeal. Investments in overseas properties can be
particularly dangerous because of misunderstandings about legal rights and
obligations and because of the danger of oversupply in certain markets.
Page 6
The property development would also cost our investor all of the liquidity that
he presently enjoys. Quoted shares can be bought and sold freely, but a
property investment requires capital to be tied up in the long term and it can be
difficult to release equity.
Q19 (iii) comments: There were some good answers which provided a solid
explanation and provided examples of specific risks the investor would be
exposed to. However, too many candidates saw the low beta and decided that
the risk was low and the returns high so it was a good idea. This topic should
be revised in depth by future candidates it comes up again and again and is
never well answered.
20 (i)
Extra depreciation
£10m × 10% = £1.0m
Extra interest
£10m × 9% × 2/12 = £150,000
Grow Ltd
Forecast income statement
for the year ended 31 December 2008
£000
Revenue 5,000
2,000
Other operating costs (500)
1,500
Net profit 630
Page 7
Grow Ltd
Forecast balance sheet
as at 31 December 2008
£000 £000
Current assets
Inventory 167
Bank 50
634
Total assets 27,134
Equity
Share capital 5,000
8,720
Non-current
liabilities
Loans 18,000

27,134
Q20 (i) comments: Errors were in the calculations rather than the placement
of the adjustments e.g. interest may have been miscalculated but the incorrect
figured was carried forward correctly and adjusted in the I/S and the B/S.
Therefore candidates tended to score high marks. The main error was
miscalculation of the interest and failing to adjust the current liabilities.
Page 8
(ii) (a)
Without asset With asset
ROCE 2,500/(9,870 + 8,000) 1,500/(8,720 + 18,000)

= 14% = 6%
Gearing 8,000/(9,870 + 8,000) 18,000/(8,720 + 18,000)

= 45% = 67%
(b) The investment will make the company appear far less profitable (due
to the lower ROCE) and far more risky (because of the much higher
gearing ratio). Thus, the investment might undermine shareholder
confidence.
Q20 (ii) comments: Generally well answered.
(iii) Shareholder wealth is a function of future cash flows. Future cash flows are
not affected by accounting choices or the accounting treatment of transactions.
Entering into a transaction that has an adverse impact on the financial
statements in the short term should not affect the long term prosperity of the
company. The directors should be able to explain the short-term distortions
arising from investments and other events.
Unfortunately, in the real world shareholders will not always accept

explanations of temporary downturns. Companies usually claim that bad
results should not be taken too seriously because they do not wish
shareholders to panic, so explanations and reassurances often carry very little
weight. Shareholders may well pay more attention to a concrete set of reported
results that have been audited than to a statement that the company is pursuing
long-term goals.
The directors might feel that their personal positions are threatened by the
effects of the transaction on the income statement and balance sheet. If the
share price is depressed by concerns about the figures then the company could
be taken over and the directors replaced.
Q20 (iii) comments: There were many good answers here. Some weaker
candidates misunderstood the question and discussed the ethics behind
accounts manipulation, or deduced that as gearing had gone up and ROCE
down the project was less profitable and was not worthwhile. On the whole
this was done reasonably well.
Page 9
EXAMINATION
23 April 2009 (am)

Core Technical
booklet.
supervisor.
question paper.
correct.
1 A company’s ordinary shares have a nominal value of 25p. The current market price
of a share is 90p. The directors are planning to issue new shares. Which of the
following statements best describes the restrictions on the issue price for the new
shares?
A The directors are not permitted to issue the shares for less than 25p or for more
than 90p.
B The directors are not permitted to issue the shares for less than 25p and are
unlikely to be able to sell them for more than 90p.
C The directors are not permitted to issue the shares for more than 90p, but can
sell them for any amount below that.
D The directors are not permitted to sell the shares for less than 90p.
[2]
2 A company renews its bank overdraft facility in September of every year and last
renewed it in September 2008. The company went overdrawn in February 2009 by an
amount that was less than the overdraft facility. The finance director gave the bank
manager a cash forecast that indicates that the overdraft is likely to be repaid in June
2009.
Which of the following is the earliest that the bank would be permitted to demand
settlement of the amount borrowed on overdraft?
A immediately
B June 2009
C September 2009
D never, so long as the company remains within agreed overdraft limits
[2]
CT2 A2009—2
3 A UK manufacturing company has entered into a futures contract that requires it to
deliver an agreed sum of $US to a counterparty at an agreed date in the future. Which
of the following best describes the likely impact on the manufacturing company’s
margin on the contract if the value of the $US rises against the company’s home
currency?
A Some of the margin paid to date will be returned to the company.
B The margin will remain unchanged.
C An additional margin will have to be deposited by the manufacturing

company.
D The margin will have to be renegotiated between the two parties to the
contract.
[2]
4 An actuarial consultancy is due to receive a substantial payment in $US from an

overseas client on 31 July 2009. It has decided to purchase an option to protect itself
from fluctuations in the value of the $US. Which of the following attributes is the
most important aspect of the option contract?
A It should be an American option.

B It should be a European option.
C It should be a call option to buy dollars.
D It should be a put option to sell dollars.
[2]
5 Which of the following is a realistic “worst case” scenario for an issuing house that
has underwritten a share issue?
A There are no risks associated with underwriting share issues.
B The underwriter may not receive the agreed fee in full.
C The underwriter may have to purchase some shares and either hold them or
resell them at a loss.
D The underwriter may be exposed to a potentially unrestricted loss.

[2]

6 Which of the following is NOT a potentially valid interpretation of the fact that the
creditors’ turnover period based on figures from a company’s annual report is very
rapid?
A The company wishes to maintain an excellent relationship with its suppliers.

B There are limitations in the relevance of the figures in the annual report.
C The company is having difficulty in obtaining trade credit.
D The company has no liquidity problems.
[2]
7 A company has asked a potential supplier to provide trade credit and has submitted its
most recent set of audited financial statements to demonstrate its liquidity position.
Which of the following is the most likely limitation of the financial statements for this
purpose?
A It is impossible to assess liquidity from published financial statements.

B The statements are liable to have been distorted.
C The statements have been prepared by the directors and lack credibility.
D The statements will be out of date for this purpose.
[2]
8 Which of the following is likely to cause the greatest concern for a shareholder who
wishes to analyse the liquidity position of a company?
A an increasing current ratio

B an increasing quick ratio
C a declining current ratio
D a declining quick ratio
[2]
9 Which of the following best describes the responsibility of an external auditor?
A to express an opinion on the financial statements

B to certify the accuracy of the financial statements
C to eliminate agency problems
D to express an opinion on corporate governance matters
[2]
CT2 A2009—4
10 A company has inventories of £500,000, trade receivables of £600,000, a bank
overdraft of £200,000 and trade payables of £450,000. What is the company’s quick
ratio?
A 0.8:1
B 0.9:1
C 1.3:1
D 1.7:1
[2]
11 Two actuaries have decided to go into business. They intend to borrow heavily in
order to pay a substantial deposit on the rental of premises, to invest in computers and
other equipment and to meet routine running costs for the first few months of
operations.
The actuaries do not wish to accept personal risk for the liabilities of the business and
have decided to form a limited company.
Explain the extent to which the actuaries will succeed in avoiding personal liability by
incorporating their business as a limited company.
[5]
12 In many countries companies are not permitted to treat depreciation as an expense for
tax purposes. Instead, they are allowed to deduct a capital allowance, which is
effectively a depreciation charge that is calculated in a very rigid and prescriptive
manner.
Explain why tax rules deal with depreciation in this manner. [5]
13 Describe the risks associated with investing in debenture stocks. [5]
14 Explain why the directors of a company might wish to have a steady and consistent
dividend policy. [5]
15 A company has several divisions, each of which operates on a geographical basis and
in the same line of business. Divisional managers can submit proposals for capital
investment projects for consideration by senior management at head office. An
analysis of proposals received in the past three years indicates that some divisional
managers submit far more proposals than others and that some divisional managers
are consistently more optimistic than others in their proposals.
Explain why such behaviour might occur and why it creates problems for companies.
[5]

16 Describe the purpose of the standard setting system that regulates the preparation of
published financial statements. [5]
17 Explain, using examples, how the directors of a limited company could create a
misleading impression of their company’s profitability in the published financial
statements. [5]
18 Discuss whether the maximisation of shareholder wealth can be realistically regarded

as the guiding principle by which companies are managed. [5]
19 The following information was extracted from the accounting records of Maker plc:
Maker plc
Trial balance as at 31 March 2009
£m
Administrative expenses 24
Bank overdraft 6
Delivery vehicles – cost 380
Delivery vehicles – depreciation 140
Factory – cost 600
Factory – depreciation 64
Interest paid 120
Inventory at end of year 16
Long term loan 600
Machinery – cost 580
Machinery – depreciation 160
Manufacturing costs 34
Raw materials consumed 440
Retained earnings as at start of year 166
Running costs for delivery vehicles 80
Sales 1,200
Share capital 220
Trade payables 52
Wages – administrative staff 42
Wages – delivery drivers 28
Wages – manufacturing staff 124
The directors had the factory revalued on 1 April 2008. It was valued at £700m,
although this valuation has not yet been incorporated into the company’s bookkeeping
records.
CT2 A2009—6
Depreciation has yet to be charged on the non-current assets. The following rates are
to be used:
• Factory 2% of cost or more recent valuation

• Delivery vehicles 25% reducing balance
• Machinery 10% of cost
(i) Prepare, using the above information, an income statement for the year ended
31 March 2009 and a balance sheet as at that date. [12]
(ii) Outline the advantages and disadvantages of revaluing the factory. [4]
(iii) At 1 April 2008 the company had a positive bank balance of £4m. Explain
why the change in the balance from the opening figure to that shown in the
above trial balance might differ from the profit or loss calculated in your
income statement. [4]
[Total 20]

20 You have been asked to clarify a number of matters for the board of directors of a
major company that is considering a massive investment. The directors have decided
that all major investments will be evaluated in terms of their net present value (NPV)
and that NPV will be determined in a relevant and meaningful manner.
Unfortunately, they cannot agree on the application of the best way to calculate NPV.
The company has a beta coefficient of 1.6. It has a market capitalisation of £60
million. The company is financed entirely by equity. The directors believe that their
high beta coefficient has depressed the market capitalisation and so they wish to
invest in some new lines of business.
The directors are considering an investment that will reduce the company’s beta.
They intend to borrow £20 million at an interest rate of 8%. They intend to invest the
whole amount in a new business venture that is significantly different from the
present business. This venture is in a business area where companies traditionally
have beta coefficients of approximately 1.1, although the directors feel that the
business is so different from the existing industry that there is an even greater
diversification effect.
The directors are considering evaluating the NPV of the investment in terms of the
company’s present cost of equity, although two members of the board believe that this
rate is theoretically incorrect. One board member believes that the cost of equity will
be affected by the investment and that it should be used in place of the present rate
and another believes that the weighted average cost of capital, revised to allow for the
fresh investment and the new borrowing, should be used.
The risk free rate of return is 4%. The market risk premium is 6%. The company’s
effective tax rate is 28%.
(i) Use the capital asset pricing model (CAPM) to:
(a) Calculate the company’s present cost of equity.
(b) Estimate the company’s ungeared beta, assuming that it proceeds with
the investment.
(c) Estimate the company’s geared beta, assuming that it proceeds with the
investment.
(d) Determine the company’s weighted average cost of capital to proceed

with the investment, using the results of your other calculations and
estimates.
[8]
(ii) (a) Discuss the appropriateness of the directors’ decision to determine the
NPV of the proposed investment in terms of one or other of the
measures of the company’s cost of capital.
(b) State, with reasons, whether there is a more appropriate rate that should
be used instead. [6]
CT2 A2009—8
(iii) Explain why the directors are mistaken in their belief that their investment in
this new venture is even more worthwhile to the shareholders because of the
additional diversification effect that it carries. [6]
[Total 20]
END OF PAPER
CT2 A2009—9

Core Technical
EXAMINERS’ REPORT
April 2009
Introduction
R D Muckart
June 2009
Comments
This paper was generally done fairly well by candidates which is reflected in the better pass
rate achieved for this diet.
The marks were better than the previous diet which is excellent.
Most questions were done well by candidates. The poorest answers were for the last question
on risk. Candidates can do the calculations well but have difficulty answering questions
about them.
Some revision of that area is required.
It is heartening to see an improvement in the standard of answers, hopefully this will continue
in the future.
Where relevant, comments for individual questions are given after each of the solutions that
follow.
1 B
2 A
3 C
4 D
5 C
6 D
7 D
8 D
9 A
10 B
Working for question 10:
A = 500 / (200 + 450)

B = 600 / (200 + 450) = quick ratio
C = 600 / 450
D = (500 + 600) / (200 + 450) = current ratio
Questions 1 to 10 were done well by most candidates.
Page 2
11 In theory, incorporating as a limited company would restrict all claims to the

company’s assets. In theory, the worst that could happen would be for the two
actuaries to lose everything that they have invested in the company.
In practice, it is unlikely that a lender would be so naïve. The company’s assets are
unlikely to amount to much as security for any loan. The rental deposit will probably
go to the landlord to pay any rent arrears if the company fails, the IT equipment will
have very little second hand value and the money spent on running costs will have no
residual value.
Any rational lender is likely to demand a personal guarantee from the two actuaries as
a condition of granting the loan. Incorporation is only likely to protect the actuaries
from smaller creditors who did not take the precaution of seeking a guarantee.
This question was done reasonably well by candidates. Few candidates mentioned a
personal guarantee which was surprising, but on the whole many good answers were given to
this question.
12 The tax authorities do not wish to give companies too much discretion over the
calculation of their taxable profit. The figure for depreciation can be affected by a
host of estimates and assumptions about asset lives and residual values. This means
that taxable profit would be open to manipulation in the event that the company felt
that the tax charge would otherwise be too high. It would be difficult, if not
impossible, to prove that an estimated useful life for depreciation purposes was too
short if the company appeared to be overstating depreciation. Even if the tax
authorities had the power to challenge such assumptions, this would lead to a great
deal of time and energy being directed towards checking and negotiating assumptions.
The rules for the calculation of capital allowances may be unrealistic in terms of their
estimates of residual values or asset lives, but they remove the element of subjectivity
from the process.
This question was not done especially well. Candidates discussed all they knew about tax but
did not focus on what was being asked. There was little discussion on the problem of asset
lives and the lack of subjectivity in the capital allowance calculation.
Many candidates wasted time by discussing the different methods of calculating depreciation.
Page 3
13 Debenture stock is normally backed by assets which reduces risk. Likewise,

debenture holders are usually preferred creditors and have either a fixed or floating
charge over assets.
The value of debentures will fluctuate in line with prevailing interest rates. If interest
rates rise then the cash flows from the debenture will be worth less because they will
be discounted at a higher rate.
Debentures might not be particularly liquid investments. Even if the company is

quoted it may prove difficult to find a buyer to close out a position.
Debenture stock is subject to the same inflation risk as other fixed interest securities.
This question was generally done well by candidates.
14 It is unclear whether any particular dividend policy is better than the others.
Modigliani and Miller (MM) argue that shareholders can achieve their own desired
dividend policy and thereby render the dividend decision irrelevant.
Dividends are, however, a major signal of management’s confidence. Any

disturbance of a steady stream of dividends may be very difficult to manage. It may
be the absolute value of dividends that matters, but the policy adopted by management
may affect the volatility of dividend payments.
Even MM acknowledge that there may be a tax element to shareholders’ preferred

dividend strategies. Any shift in policy could affect shareholders who prefer income
to capital gains or vice versa and hence affect the share price.
This question was poorly attempted by a number of candidates. The tax effect was ignored
and there was no mention of theory.
That left candidates with little to say and several candidates missed this question out.
15 Managers often have their own personal agendas in running departments, divisions or
business segments. A manager might wish to attract capital investment in order to
build a personal empire in the quest for promotion or greater recognition within the
organisation. Optimistic capital investment proposals will be more likely to attract
funding and so optimism may be in those managers’ personal interests.
Not all managers behave in this way. Some are motivated more by loyalty to the
company than by their own personal ambitions. Thus, senior management cannot
necessarily distinguish borderline projects that should be rejected because of
excessive optimism from those that have been evaluated in a conservative manner.
Ultimately, it may take several years to detect undue optimism on the part of
particular managers.
This question was answered well by candidates which was excellent.
Page 4
16 Accounting statements provide an important basis for the shareholders to monitor and
control the behaviour of their directors. That creates a great deal of pressure for the
directors to manipulate the figures through the use of inappropriate accounting
policies. The standard setting system is intended to reduce the numbers of acceptable
treatments for specific accounting issues, with a view to standardising those
treatments in use.
Standards should enable shareholders to have greater confidence in the figures and so
they should reduce some of the problems of resolving agency issues. Thus,
companies should find it easier to raise equity because shareholders will have grater
confidence in the information being provided to them.
The standard setting process also enhances the credibility of the accountancy
profession. Society may lose confidence in accounting statements in the wake of
accounting “scandals” and anything that can be done to prevent those from occurring
will only enhance the profession’s standing.
This question was answered well by most candidates. Most candidates managed to come up
with enough reasons for having accounting standards to get a good mark for this question.
17 The directors might bias any estimates or assumptions in order to improve the
impression created by the published figures. For example, closing inventory has to be
valued at the lower of cost and net realisable value, with profit being affected by this
valuation. An optimistic assumption about the net realisable value of every item in
inventory will boost profits.
It may be possible to time transactions so that profits are enhanced. For example,
offering discounts towards the year end to encourage customers to enter into contracts
sooner than they might do otherwise would boost profits for the present year at the
expense of the next.
Timing major capital transactions might also enhance the profitability figures.
Delaying the acquisition of non-current assets may reduce capital employed by
enough to more than compensate for the reduction in activity due to the weaker asset
base.
Companies may indulge in creative accounting practices by looking for loopholes in

accounting standards that permit the reporting of higher profit figures.
This question was done reasonably well by many candidates , however some could not think
of any examples to illustrate the points they had made. Good examples will always enhance
an answer so it is worth trying to think of some in advance when revising.
Page 5
18 In theory, maximisation of shareholder wealth offers a simple and effective objective

for evaluating managerial decisions. It is easy to justify the selection of a measure
than increases shareholder wealth because it is clearly in line with shareholders
objectives, and even allows for the interaction between risk and return.
In practice, it may be difficult to envisage the directors acting in this way. There are
many ways in which maximising shareholder wealth could be against the directors’
best interests. For example, shareholders can diversify risks in ways that directors
cannot and so directors may be more risk averse in decision making than shareholders
would prefer. Many directors have sufficient integrity to overcome any such
pressures, but it will be difficult to distinguish them from those who have not.
This question was answered well by many candidates. Most agreed that maximising
shareholder wealth was the main objective for companies. This is a generally accepted
position and most other arguments are not valid.
19 (i)
Maker plc
Income Statement
for the year ended 31 March 2009
£m
Revenue 1,200
Cost of sales (670)
Gross profit 530
Distribution costs (168)
Administrative expenses (66)
Finance costs (120)
Profit for the year 176
Maker plc
Balance sheet
as at 31 March 2009
£m
ASSETS
Non-current assets (note 1) 1,228
Current assets
Inventories 16
156
Total assets 1,384
Page 6

Equity
Share capital 220
Total equity 726
Loan 600
Current liabilities
Trade payables 52
Bank overdraft 6
Total current liabilities 58
Total liabilities 658
Total equity and liabilities 1,384
Notes
(1) Non-current assets

Net book
Cost/valuation Depreciation value
£m £m £m
Factory 700 (14) 686
Machinery 580 (218) 362
Delivery vehicles 380 (200) 180
1,660 (432) 1,228
Page 7
Workings
Depreciation
Delivery vehicles (380–140)*25% = 60
Factory 700*2% 14
Machinery 580*10% 58
Cost of sales
Depreciation – factory 14
Depreciation – machinery 58
Manufacturing costs 34
Raw materials 440
Wages 124
670
Distribution costs
Depreciation - vehicles 60
Vehicle running costs 80
Wages 28
168
Administration
Expenses 24
Wages 42
66
Revaluation reserve
Cost 600
Depreciation (64)
Book value 536
Valuation 700
Gain 164
(ii) The main advantage is that shareholders will have a better idea of the value of
the property that their company controls. That should give a more realistic
insight into the resources used by the company in order to generate income. A
value might also enable the shareholders to make sensible decisions about,
say, whether the property should be retained or sold.
The biggest disadvantage of a valuation is that it will be subjective and will be

open to manipulation. There may be professional fees associated with
Page 8
determining the value. Another disadvantage is that it reduces the return on

capital employed.
(iii) There are many transactions that might affect the bank balance but have no
impact on profit, for example, the repayment of a loan. This appears to have
happened part of the way through the year because the company has a very
high interest charge relative to the amount borrowed at the year end.
Profit does not always generate cash immediately. Credit sales will be
recognised before any cash is generated. Companies can even run into a
problem called “overtrading” when they are growing and start to put a strain
on their working capital.
Part (i) of this question was really well answered by candidates with many candidates
scoring full marks. There were some variations in where to show some items but generally
the attempts at this were very good. It is excellent that so many candidates can prepare
accounts so well.
Part (ii) This part was done reasonably well with many candidates scoring a high mark.
Most candidates mentioned subjectivity and the fact that 2 valuers may give different
valuation for the same property.
Part (iii) Most candidates scored a reasonable mark for this part of the question. Well done!
20 (i) Present cost of equity = 4% + (1.6 × 6%) = 13.6%
Estimated ungeared beta, with investment

= (1.6 × 60/80) + (1.1 × 20/80) = 1.475
Working: Debt/equity ratio = 20/60 = 0.333
Estimated geared beta, with investment = 1.475 × (1 + (0.333 × (1 – 0.28))

= 1.829
Working: cost of equity, with investment = 4%+ (1.829 × 6%) = 14.974%

cost of debt = 8% × (1 – 0.28) = 5.76%
Weighted average cost of capital = (14.974 × 60/80) + (5.76% × 20/80)

= 12.670%
(ii) Arguably, each project should be evaluated in terms of its own individual risk.
That means that the cost of capital is only an appropriate rate if the investment
constitutes an overall expansion of the business. Even then, it is debatable
whether the markets will view the expansion as having the same risk as the
company as a whole. The existing cost of capital is, at best, a rough
approximation to an appropriate discount rate.
Page 9
The managers could, in fact, use the project’s beta coefficient to calculate the
relevant discount rate. With a beta of 1.1, the project should be discounted at
4% + (1.1 × 6%) = 10.6%.
(iii) The directors are mistaken because the project should really be evaluated in
terms of its impact on shareholder wealth. The shareholders should have
diversified portfolios already, so the additional diversification from this
project should not really do them any good. The project has a lower beta than
the company as a whole, so the project will reduce the shareholder’s weighted
average beta and reduce their overall risk profile. That is not necessarily a
good thing because the shareholders may prefer a slightly higher risk in order
to generate a slightly higher expected return.
Arguably, the directors will be the only real beneficiaries of the diversification
effect. The fact that most directors will derive most of their income from that
one company and that they have their career tied up in it will make them more
exposed to any risks.
Part (i) Generally candidates did well in this part of the question. Most candidates were
familiar with the calculations required. Unfortunately there were some candidates who
scored zero for this part and they must revise this topic for the future.
Part (ii) This part was done very poorly with many candidates scoring zero marks. Again
some revision of this topic is required before the next attempt.
Part (iii) This part of the question was also done very badly. Candidates showed very little
understanding of the topic of risk. Candidates did mention diversifying portfolios but not in
enough depth to get a high mark. Although candidates can do the calculations for this topic
they seem to lack understanding of the topic and do not know what the calculations show.
This is very important and should be revised.
This whole topic requires some revision.
Page 10
EXAMINATION
2 October 2009 (am)

Core Technical
booklet.
supervisor.
question paper.
correct.
1 Mark has entered into a limited liability partnership (LLP) with three other
consultants. Mark has invested £50,000 and has agreed to accept a 20% share of all
profits and losses.
Which of the following best describes Mark’s exposure as a result of entering into this
agreement?
A He could lose his entire investment in the partnership.
B He could lose his entire investment in the partnership and be personally liable
for up to 20% of any unrelieved liabilities after the partnership assets have
been exhausted.
C He could lose his entire investment in the partnership and be personally liable
for up to one quarter of any unrelieved liabilities after the partnership assets
have been exhausted.
D He could lose his entire investment in the partnership and be personally liable
for the whole of any unrelieved liabilities after the partnership assets have
been exhausted.
[2]
2 Which of the following best describes the cost of trade credit as a source of finance?
A Trade credit is free.
B Trade credit is free provided the goods are paid for within the agreed period.
C Trade credit is free, but there is a reputational cost to buying goods on credit.
D Trade credit is not free, but the cost is included as part of the purchase price of
the goods.
[2]
3 Company A has sold a put option for 1,000 shares in quoted Company B. The option
exercise price is £5 per share. Company A received a premium of £500. The expiry
date was set three months from the date the option was sold. What is Company A’s
maximum exposure to loss on this option contract?
A £500
B £4,500
C £5,000
D no specific upper limit
[2]
CT2 S2009—2
4 A shareholder of a quoted company has received an invitation to subscribe to a rights
issue at a discount to the current share price. The shareholder cannot afford to take up
this invitation. Which of the following best describes the protection available to the
shareholder’s position?
A The right to buy can be sold for an amount that should compensate for the loss
in value due to the dilution.
B The shareholder can vote to block the issue.
C The stock market will react favourably to the news that the directors are
raising funds with which to expand.
D The shareholder can sell the shares before the rights issue occurs.
[2]
5 A quoted company has been paying substantial dividends for several years. It
recently announced that it would maintain its dividend compared to last year and that
it would be making a rights issue in the very near future in order to finance an
investment project. The amounts and timings of both the dividend payment and the
rights issue are very similar.
Which of the following is the most likely explanation for this behaviour?
A A rights issue is perceived as a sign of confidence by the markets.
B It would be less expensive to raise finance by way of a rights issue rather than
to suspend the dividend.
C It would be less expensive to finance the new investment with share capital
rather than retained earnings.
D The directors are concerned that the shareholders will view a reduction in
dividend as indicative of problems with the company.
[2]
6 Which of the following best describes current assets?
A all of the assets owned as at the balance sheet date
B physical assets that can be seen and touched
C non-physical assets
D cash and items that will be converted into cash in the normal course of
business
[2]

7 A company has issued some fixed interest loan stock with a warrant attached. Which
of the following is NOT an advantage of attaching a warrant to the stock?
A The warrant will not create any cash outflow.

B It might be easier to sell the loan stock.
C The company’s equity may become diluted.
D The rate of interest offered to lenders may be reduced.
[2]
8 A company’s income statement includes the cost of electricity that was consumed
during the year, but was not paid for until some time during the following year.
Which of the following accounting concepts requires this treatment of the electricity
cost?
A accruals
B business entity
C going concern
D money measurement
[2]
9 A project has a very small positive net present value. Investing in this project will not
prevent the company from investing in any of the other opportunities that are
available to it. Which of the following best describes the manner in which the
company should proceed?
A The project should be accepted because it is generating an acceptable rate of

return.
B The project should be accepted because it will not involve a great deal of risk.
C The project should be rejected because it will not increase shareholder wealth
by very much.
D The project should be rejected because the cash could be put to better use.
[2]
10 A company’s loan stock has a nominal value of £10m and pays interest at a rate of 8%
per annum on that amount. The market value of the loan stock is £7m. The company
has made losses for tax purposes in excess of £2m per year and anticipates that it will
continue to do so for at least the period up until the repayment of the loan stock.
Which of the following best describes the company’s cost of debt?
A less than 8%, but subject to an adjustment for tax

B less than 8% without any adjustment for tax
C more than 8%, but subject to an adjustment for tax
D more than 8% without any adjustment for tax
[2]
CT2 S2009—4
11 Explain why a finance lease has effectively all of the attributes of taking out a loan in
order to purchase an asset outright. [5]
12 Explain why many taxpayers have a preference for capital gains over earned income
when the choice arises. [5]
13 Explain why a company might wish to issue preference shares rather than loan stock.
[5]
14 Explain why property companies frequently raise a high proportion of their long term
financing from debt rather than from equity. [5]
15 Discuss the difficulties associated with accounting for the depreciation of property,
plant and equipment in a company’s financial statements. [5]
16 Explain how the shareholder value approach to capital project appraisal relates to
more traditional net present value approaches. [5]
17 Goodwill on consolidation arises when a buyer pays more than the book value of the
net assets for an investment in a subsidiary.
Explain the circumstances in which it might be logical to pay more for a company
than its balance sheet indicates that it is worth. [5]
18 Explain the role of the external auditor of a limited company. [5]

19 One of your friends has inherited a substantial investment in an unquoted company
that manufactures electrical components. Your friend has asked you to analyse the last
two years’ financial statements in order to obtain an understanding of the company’s
profitability and risk profile.
Your friend has provided you with the following information:
Makegoods PLC
Income statement for the year ended 31 August
2009 2008
£000 £000
Revenue 8,400 6,000
Cost of sales (3,360) (2,820)
Gross profit 5,040 3,180
Distribution costs (504) (180)
Administrative expenses (168) (90)
Operating profit 4,368 2,910
Finance costs (632) (187)
Net profit before tax 3,736 2,723
Tax expense (1,020) (766)
Profit for the year 2,716 1,957
Dividend paid 2,000 1,000
CT2 S2009—6
Makegoods PLC
Balance sheet as at 31 August
2009 2008
£000 £000
ASSETS
Non-current assets
Property 5,000 5,000
Plant and equipment 7,000 2,000
Total non-current assets 12,000 7,000
Current assets
Inventories 280 235
Trade receivables 700 500
Cash at bank 10 10
990 745
Total assets 12,990 7,745

Equity
Share capital 2,000 2,000
Retained earnings 2,816 2,100
Total equity 4,816 4,100
Long-term borrowings 6,934 2,675
Current liabilities
Trade payables 240 190
Current tax payable 1,000 780
1,240 970
Total liabilities 8,174 3,645

Total equity and liabilities 12,990 7,745
The company sells goods to specialist suppliers for resale to end users. During the
year ended 31 August 2009 it introduced a new range of products.
(i) Discuss the profitability and risks faced by this company. Your discussion
should be supported by relevant ratios. [14]
(ii) Discuss the usefulness of the information contained in a typical company’s

annual report for the type of analysis that you conducted in part (i) above. [6]
[Total 20]

20 The directors of Homevac plc are considering a major investment proposal. The
company was established 12 years ago to manufacture innovative consumer goods,
such as food mixers that enable amateur cooks to produce professional results. The
company was founded by Ivy Lee, who invented the basic product range. Much of
the company’s long-term funding came from venture capitalists and some banks. It
has grown rapidly, but remains unquoted. Ms Lee is still the majority shareholder,
although the venture capital organisations are represented on the board.
The venture capitalists are keen to see the company expand with a view to it seeking a
stock market quotation. They have conducted some initial research into the
possibility of relocating the company’s factory to a developing country where labour
is relatively inexpensive. The net present value of this proposal is positive under a
range of assumptions about costs and revenues, including the worst likely case and
using a realistic discount rate.
Ms Lee is concerned about this proposal on two grounds:
• Homevac plc makes most of its sales in its home country and has been successful
in part because the company is very strongly identified as a “local business”. She
feels that there are risks that cannot be captured in a typical discounted cash flow
analysis and that a higher-level risk analysis should be conducted.
• All of her wealth is tied up in the company. She is not opposed to relocating the
factory in principle, but she would require far more than a “realistic” rate of
return. She wishes the proposed investment to be evaluated at a required rate of
return of 25%.
(i) Explain why it might be appropriate for the directors to identify the major
higher-level risks that might affect the outcome of this project. [3]
(ii) Outline the main risks facing this project. [7]
(iii) Explain why it might be reasonable for Ms Lee to require a higher rate of
return than one that had been determined by traditional investment appraisal
techniques. [4]
(iv) Discuss the advantages and disadvantages to the owners of Homevac plc of
seeking a stock market quotation. [6]
[Total 20]
END OF PAPER
CT2 S2009—8

Core Technical
September 2009 examinations
EXAMINERS’ REPORT
Introduction
R D Muckart
December 2009
Comments for individual questions are given with the solutions that follow.
Subject CT2 (Finance and Financial Reporting Core Technical) — September 2009 —Examiners’
Report
The results were somewhat disappointing this time as the paper seemed to be of the same standard as the
previous diet. Many answers were very brief and lacked substance. The worst section was probably the short 5
mark questions , some of the answers to theses were very poor.
Candidates should study the whole syllabus so they can attempt each question, it is a dangerous strategy to only
study some topics and expect to be able to make general comments for the rest of the questions.
Question 19 was done very well and is clearly a topic that candidates find straightforward which is very good.
1
The answer was A
2
The answer was D
3
The answer was B
4
The answer was A
5
The answer was D
6
The answer was D
7
The answer was C
8
The answer was A
9
The answer was A
10
Page 2
Subject CT2 (Finance and Financial Reporting Core Technical) — September 2009 — Marking
Schedule
The answer was D
The MCQs were done very well by most candidates which was excellent and very heartening.
11
A finance lease will normally last for the useful life of the asset. The lessee will bear the risks of the
asset becoming obsolete during its lifetime or of it becoming surplus to requirements. As with a loan,
the cash flows will, presumably, be sufficient to enable the lessor to recover the cost of the asset
effectively with interest. The lessor will have the same rights to repossess the asset as a lender who had
secured a loan against the asset.
From an accounting point of view, a finance lease is accounted for as if the asset had been purchased
outright with a loan.
The answers to this question were usually very superficial. The most common mark was a marginal
fail. Candidates should try to go into more detail in their answers.
12
Taxpayers may pay income tax at a higher marginal rate than the rate at which capital gains are taxed.
Many taxpayers will have an unused allowance for capital gains. These factors combine to make capital
gains tax less expensive than income tax for most taxpayers.
Capital gains are not normally taxed until the gains are realised, whereas income is taxed when it is
earned. That means that there can be a lot more scope for planning the timing and payment of capital
gains tax. Transactions can be brought forward or delayed to recognise a gain in the most suitable
period.
This question was answered well with most candidates being well versed in capital gains tax.
13
The biggest advantage is that the penalties for any failure are less severe. The capital may not be
repayable or redeemable, unlike a loan which is likely to be for a finite period. The dividends may be
equivalent to interest, or even higher, but the penalties for any failure to pay the dividend are likely to
be no worse than the company being forbidden to pay an ordinary dividend. In some cases, any unpaid
dividends will be foregone and the company will have no ongoing commitment to pay these when it
returns to profit.
Preference shares rank behind all liabilities in the event of failure. Thus, lenders will be happier to see
preference shares issued rather than additional borrowing.
Some corporation tax payers can enjoy a higher return after tax from preference shares than from loan
stock, thereby making it cheaper to issue preference shares to them.
101 A2003—3 PLEASE TURN OVER

Report
This question was done reasonably well, again a little more detail would have improved the answers.
Most candidates showed good knowledge of this topic which was great.
14
A property company can offer a lender security against its assets. That means that a lender would be
less concerned about the risk of default because the collateral should ensure that the capital will be
repaid.
A property company is also likely to raise a steady stream of income from tenants. That means that it
can take on higher borrowing because it knows that it will be able to service them from rental income.
The investment in property is likely to yield a steady capital gain over the long term, with a relatively
low risk. The returns are unlikely to be high and raising funds from borrowing will be cheaper than
using equity.
The answers to this were very vague and waffly. Not a topic that was understood by the majority of
candidates. This was surprising. Answers were just too general.
15
Calculating depreciation depends on major assumptions. The company has to estimate the useful life of
the asset and the residual value. Both figures are subject to massive uncertainty. For example, useful
life can be affected by physical characteristics such as wear and tear, by technical issues such as the
possibility of obsolescence and even by commercial factors such as the possibility that demand might
change and leave an asset worthless.
The company must also decide how the difference between cost and residual value should be written
off. For example, the choice between straight line and reducing balance depreciation can significantly
affect the annual depreciation charge.
This question was fairly straightforward and was done badly by many candidates. The question did not
ask how to calculate depreciation which is what many candidates answered. This approach got low
marks. Candidates must read the questions carefully and make sure they answer what is asked.
16
Capital project appraisal normally involves deciding on the shareholders' behalf whether an investment
should be undertaken. That involves having a decision rule such as NPV or IRR and investing in
projects that best meet the criteria.
The shareholder value approach takes account of how that project will be received by the shareholders
and markets. In theory, any positive NPV project should enhance shareholder value, but the
shareholders will not have all of the information available to the directors. Even if they had, they would
not necessarily process that information in the same way. The directors have to consider how news of
the project is likely to be received by the markets. That might involve considering how the indicators
used by shareholders might be affected, such as the EPS or dividend.
Page 4
Schedule
This question was answered well. Project appraisal is a topic that candidates had studied and gave
good clear answers which is hearening.
17
The money measurement concept means that the financial statements only reflect those assets that can
be valued objectively in monetary terms. This means that the balance sheet may well exclude extremely
valuable assets such as customer loyalty. It is highly unlikely that it would be possible to buy the
company without paying for such assets, with their value being determined by a process of negotiation
between the buyer and the seller.
Consolidation implies the acquisition of a controlling interest. It might be sensible to pay more than the
book value in order to obtain control if the buyer feels that a change of management would enable the
company to perform more effectively. Individual shareholders would normally expect the buyer to pay
a premium for control and so the share price will tend to rise when the possibility of a takeover is
announced.
This question was not done very well. Many candidates gave very vague low level answers which got
low marks.It was clear that many candidates were just making up a general answer and had very little
idea about this area.
18
The external auditor’s primary role is to express an opinion on the truth and fairness of the published
financial statements. This is necessary because these statements are used to resolve many of the agency
issues that arise between the directors and the shareholders. The shareholders can only rely on the
statements if they can be satisfied that the financial statements have not been distorted or manipulated
by the directors. The auditor gathers evidence on the accuracy of the information in the bookkeeping
records and examines the accounting policies used in the preparation of the financial statements. A
clean audit opinion is not a guarantee, but it does give the readers some reassurance that the statements
have been prepared properly and are a credible basis for making decisions.
This question was done very well by most candidates which was excellent.
19
(i)
2009 2008
Profitability
Return on capital employed 4,368/(4,816+6,934) = 37% 2,910/(4,100+2,675) = 43%
Gross profit percent 5,040/8,400 = 60% 3,180/6,000 = 53%
Distribution costs/sales 504/8,400 = 6% 180/6,000 = 3%
Revenue/fixed assets 8,400/12,000 = £0.70 6,000/7,000 = £0.86

Report
Risk
Gearing 6,934/(4,816+6,934) = 59% 2,675/(4,100+2675) = 39%
Current ratio 990/1,240 = 0.8:1 745/970 = 0.8:1
Quick ratio 710/1,240 = 0.6:1 510/970 = 0.5:1
At first glance, the company seems to have boosted revenue and profit. The move to a new range of
products has boosted the gross profit percentage. The company has, however, become less profitable
because return on capital employed has declined. This decline appears to have arisen because of the
investment in machinery. Each £1 of machinery generated £0.70 of revenue, which is rather less than
the £0.86 that was generated in 2008. Another factor is the doubling of the percentage of revenue spent
on distribution. The new product range may require a greater sales effort.
The important question to ask is whether this is a transitional period. If the company only installed the
equipment during the year and then operated it at less than full capacity then the return on capital
employed and revenue to fixed assets ratios will both be artificially depressed.
The risks have also increased significantly. Gearing has gone up from 39% to 59%, thereby increasing
any volatility to the shareholders. The liquidity ratios are low, although that may be less of a problem
because the company had a similar set of liquidity ratios in 2008 and it has survived since.
(ii) The main problem with the annual report is that it provides only limited amounts of detail. It would
be extremely useful to have had a full analysis of the new venture in the annual report, but none would
have been provided. Companies are reluctant to publish information that could be used by their
competitors. It would be useful to know how management feels that the new product will develop over
time, but such predictions are fraught with difficulties. If management is over pessimistic then the
shareholders might question the wisdom of the investment, but optimism could lead to disappointment
and an overreaction if things do not work out.
Some of the information in the annual report will also date very quickly. For example, the liquidity
position will change from day to day.
This question was done very well by candidates which was excellent.
The calculations were excellent in most cases but the written explanation was usually brief and lacking
substance. The calculations pulled the marks up and made this one of the best answered questions.
20
(i) This investment is a major strategic decision. It is not really sufficient to set a single criterion for
this and then analyse the project because the decision is far more complicated and requires a far richer
analysis. This decision has the capacity to cause the company a great deal of harm if its implications
are not thought through and managed.
(ii) There are many different frameworks that can be used to analyse this proposal. The following
categories of risk should be considered:
Page 6
Schedule
Political The government in the home country might be rather disturbed by the fact that it is
outsourcing production. The local government might also be concerned about the implications of
relying on multinational corporations for employment. Either government could act against the
company’s interests, either through legislation or through the activities of government departments
such as the tax authorities.
Business The company seems to be very strongly identified with the home country. The brand’s
popularity might decline as a result of the move offshore.
EconomicManufacturing in one country for sale in another will create a series of currency risks that did
not arise before. If the economy of the new location is weak then there could be problems with
inflation.
(iii) Individuals have their own personal risk preferences. The “rational” analysis of an investment
project often uses market prices and thereby uses norms set as an average by the market as a whole. Ms
Lee could easily be more risk averse than the average investor.
Ms Lee does not have a balanced and diversified portfolio. She will be exposed to the total risk,
whereas market preferences are often arrived at using portfolio theory.
There are non-economic issues that could affect her decision. She may have a sense of attachment to
the original business model and might be unwilling to change that unless there is a significant reward
for doing so.
(iv) The biggest advantage of seeking a quotation is that all parties will have a clear exit route. The
venture capitalist will be able to sell their stake on the open market and move on. Ms Lee will be able
to scale down her stake in the company.
The quotation will make it easier to seek fresh equity in the future.
There are potential disadvantages. Seeking the quotation will be an expensive matter. The company
will have to invest heavily in professional fees, underwriting, etc. Ms Lee will also have to sacrifice a
great deal of control of the company. She may be able to remain the largest shareholder, but will not be
able to retain a majority shareholding. She will be answerable to a body of shareholders who may have
a different attitude towards the way in which the company should be run.
Answers to this question were generally poorer than expected. Some parts were very weak.
Part i was poor and should have been straightforward. Part ii was not as bad but some candidates had
difficulty identifying suitable risks.
Part iii was done well by some candidates but weaker candidates were poor in this part also. More
detail was required to get a good mark in this part of the question. Part 4 was reasonable but again
many candidates scored a borderline fail mark as they did not have much detail in their answer.

Report
Page 8
EXAMINATION
29 April 2010 (am)

Core Technical
booklet.
supervisor.
Graph paper is NOT required for this paper.
question paper.
correct.
1 Which of the following statements best describes the duties of a company’s board of
directors?
A The directors should maximise shareholder wealth and ignore externalities.
B The directors should maximise shareholder wealth and respect regulatory

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

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

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

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

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

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

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

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

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

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

B the chief accountant
C the external auditor
D the finance director
[2]

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

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

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

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

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

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

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

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

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

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

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

the balance sheet. [6]
[Total 20]

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

Core Technical
Introduction
R D Muckart
July 2010
Comments
These are given in italics at the end of each question.
1 B
2 A
3 D
4 D
5 A
6 A
7 A
8 C
9 A
10 A
Questions 1–10 were answered well by most candidates.
11 (a) Information asymmetry arises because the directors know more about the
management of the company than its shareholders. The directors can also have
greater confidence in the figures at their disposal because they can check the
underlying data and the manner in which the information has been prepared.
(b) Financial reporting is a vital part of assuring the shareholders that the
company is being managed properly and in their best interests. The directors
will normally be keen to signal that the figures have been prepared accurately
and in accordance with acknowledged accounting standards. Publishing
credible financial statements will simplify the process of dealing with
shareholders.
The external financial statements are likely to be subject to an independent

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Equity
Total equity 13,997
Current liabilities
Accrued interest 80
Current tax payable 1,500
2,580
Total liabilities 12,580
Page 5
(ii)
Original figures With investment

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Core Technical
Introduction
T J Birse
July 2011

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

[2]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Core Technical
booklet.
supervisor.
question paper.

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

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

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

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

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

[2]
CT2 A2012–3 PLEASE TURN OVER

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Core Technical
booklet.
supervisor.
question paper.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Core Technical
booklet.
supervisor.
question paper.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Core Technical
booklet.
supervisor.
question paper.

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

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

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

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

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

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

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

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

[2]

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

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

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

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

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

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

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

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

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

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

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

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

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

Core Technical
Introduction
D C Bowie
December 2013
 Institute and Faculty of Actuaries

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

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

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

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

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

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

on demand. Trent could easily find itself totally insolvent if it does not
improve its cash management.
The calculations of the ratios was done well by candidates the discussion was done less well.
(ii) The first question is whether it would be possible to press the event company
for more rapid payment. It looks as if the whole of August’s sales remain
unpaid. It may even be worth risking the loss of the company’s business if
Trent is going to wait so long for payment that overdraft interest swamps the
profit.
Trent should also press the credit card company. It may be easier to threaten to
move to another provider of this service.
It does not look as if matters are deteriorating with respect to inventory, but
running inventory down to less than 26 days’ holding would release cash.
Once there is greater clarity about the payment stream from both receivables,
Trent should consider raising finance to support the cash flow until the bank
account is back in credit. That may be a matter of negotiating a larger
overdraft or taking out a short-term loan. Even if the payables cannot be
collected any more quickly, matters will improve when the expansion ceases
and sales and cash flows settle to a steady equilibrium.
This part was done reasonably well.
Page 7
EXAMINATION
2 May 2014 (am)

Core Technical
booklet.
supervisor.
question on a new page.
question paper.
CT2 A2014 Institute and Faculty of Actuaries

correct.
1 Which of the following is legally responsible for the commitment owed by a limited
company to the company’s lenders?
A The company’s directors.
B The company’s external auditor.
C The company’s shareholders.
D The company’s treasurer, who negotiated the terms of the loan with the
lenders.
[2]
2 Which of the following best explains the problems arising from information
asymmetry?
A Directors do not always have sufficient information with which to reach sound
managerial decisions.
B Shareholders cannot process all of the information that is available to them.
C Shareholders feel that they do not have sufficient information to evaluate the
behaviour of the directors.
D Some shareholders are better informed than others.

[2]
3 Which of the following is most likely to explain a company’s decision to issue

subordinated debt?
A A lower rate of interest will be available.
B Existing lenders may have the right to prevent the issue of further senior debt.
C Subordinated debt may offer tax advantages.
D The shareholders will feel more secure if the company issues subordinated
debt rather than senior debt.
[2]
CT2 A2014–2
4 A company wishes to issue convertible stock with a conversion date in five years’
time.
Which of the following proposals for the conversion terms is likely to be the most
attractive to investors?
A Compulsory conversion to equity shares at the end of year five.
B Investors can choose to convert to equity shares at the end of year five. If they
do not convert then their securities will continue as loan stock indefinitely.
C Investors can choose to convert to equity shares at the end of year five. If they
do not convert then their securities will continue as loan stock that will be
redeemable after a further five years.
D Investors can choose to convert to equity shares at the end of year five. If they
do not convert then their securities will be converted to preference shares.
[2]
5 An Australian company entered into a futures contract to exchange Australian dollars

for one million US dollars on 31 July 2014. Which of the following will happen if the
US dollar strengthens against the Australian dollar?
A The Australian company will have to pay an additional margin to the

counterparty.
B The Australian company will have to pay an additional margin to the futures
clearing house.
C The Australian company will receive a partial refund of its margin payment
from the counterparty.
D The Australian company will receive a partial refund of its margin payment
from the futures clearing house.
[2]

6 A quoted company’s statement of financial position shows equity shares worth £10m,
retained earnings of £20m and non-current liabilities in the form of a £15m nominal
loan paying 7% pa interest.
The shares have a total market value of £48m and the non-current liabilities have a
market value of £18m.
The company’s cost of equity has been determined as 17% and the cost of debt as 8%.
What is the company’s weighted average cost of capital?
A 11.60%
B 14.00%
C 14.27%
D 14.55%
[2]
7 A speculator has a policy of investing all of his cash in a single company for a short
period in the hope of achieving a capital gain. The speculator is presently looking for
a company whose shares have a high beta coefficient.
Which of the following is the most rational explanation for the speculator’s desire to
identify a high beta security?
A High beta securities tend to increase in value.

B Specific risks can be diversified away and only systematic risks matter.
C The speculator expects stock market prices to strengthen.
D The speculator expects stock market prices to weaken.
[2]
8 A parent company owns a 30% holding in an associate. The associate’s profit for the
year is £8m. The associate paid a dividend of £6m. How much income will appear in
the parent’s consolidated statement of profit or loss (or income statement) in respect
of this associate?
A £1.8m
B £2.4m
C £6.0m
D £8.0m
[2]
CT2 A2014–4
9 A company owns a building that cost €800,000. Depreciation to date on the building
is €200,000. The company’s directors have decided to revalue the building at its fair
value of €950,000. What will be the balance on the company’s revaluation reserve?
A €150,000
B €200,000
C €350,000
D €750,000
[2]
10 To whom is the external auditor’s report normally addressed?
A the directors
B the lenders
C the shareholders
D the Stock Exchange
[2]
11 A quoted company has raised finance using both debt and equity instruments that are
publicly traded. One of the company’s major investment projects has failed. As
expected, the market value of the equity shares has declined in response to this news,
but the value of its debt instruments has remained unchanged.
Explain why it is possible that debt would not decline in value in these circumstances.
[5]
12 Ron works in a factory owned by Global Manufacturing (“Global”), a quoted

company. Global grants employees who have been employed by the company for
more than five years the right to purchase up to 1,000 shares every year at a 5%
discount to the share price at the date of purchase. Global’s current share price is
£4.70 per share.
Discuss the advantages and disadvantages to Ron of taking up the right to purchase
shares under this scheme. [5]
13 Discuss the suggestion made by the owner of a small UK business that it is unfair that
depreciation is not allowed as an expense for tax purposes. [5]
14 A quoted company is planning to make a rights issue on the basis of one new share
for every seven shares currently held. The present share price is £5.20. The rights
issue will be priced at £4.50. The directors intend to use the funds raised to fund a
project that they are confident will increase the company’s present market
capitalisation by 20%.
Calculate the expected price per share after the rights issue. [5]

15 A company’s current share price is £2.70. The company has written to shareholders
to offer a choice between a cash dividend of £0.50 per share or a scrip dividend of two
fully paid shares for every nine shares held.
Discuss the factors that shareholders would have to take into account when deciding
whether to take the cash or the scrip dividend. [5]
16 Discuss the difficulties associated with valuing non-current assets at their fair value
rather than their historical cost. [5]
17 Discuss the importance of the International Accounting Standards Board (IASB). [5]
18 Discuss the difficulties associated with deciding whether the going concern concept is
appropriate. [5]
19 Lomax is a quoted company that manufactures tablet computers. The directors are
considering the draft financial statements for the year ended 31 March 2014. These
figures have not yet been finalised.
Lomax’s accountant has prepared the following analysis for discussion purposes:
Draft figures Year ended

for year ended 31 March
31 March 2013, as
2014 published
Earnings per share (pence) 67 78

Price/earnings ratio as at 31 March 16 14
Earnings before interest and tax (£m) 58.2 64.8
Interest (£m) 18 18
Depreciation of property, plant and equipment (£m) 62 67
Amortisation of purchased patent rights (£m) 40 40
Share price as at 31 March (£) 12.48 13.02
Equity shares (50m £1 shares) 50 50
Depreciation is based on the expected useful lives of individual assets. A

computerised asset register determines the annual depreciation charge. Lomax’s
financial statements give the following ranges for the estimated useful lives of
property, plant and equipment in the accounting policies note:
• Buildings 20 to 50 years
• Manufacturing equipment 3 to 10 years
• Vehicles 3 to 5 years
The note states that these figures are comparable to those used by similar companies.
CT2 A2014–6
On 1 April 2012, Lomax paid £400m for the right to manufacture patented
components. The purchased rights grant the right to manufacture these components
for 20 years, but the amortisation charge for the years ended 31 March 2013 and 2014
were based on the assumption that Lomax would only manufacture this component
for 10 years. The directors are now debating whether that assumption was unduly
conservative. The research and development team does not envisage a major change
in technology and so Lomax’s directors are considering the implications of revising
the estimated useful life of the manufacturing rights from 10 years to 15 years, with
effect from 31 March 2013. These rights are Lomax’s only intangible asset and their
accounting treatment will be described in detail in the notes to the financial
statements.
The directors were concerned that the share price would decline if they published the
financial statements for the year ended 31 March 2014 as they are presently drafted.
However, revising the estimated useful life of the manufacturing rights should
enhance reported earnings and so the share price should increase.
(i) Calculate Lomax’s earnings before interest, tax, depreciation and amortisation
(EBITDA) for the year ended 31 March 2014, explaining why investment
analysts often use this figure as the basis for measuring financial performance.
[5]
(ii) Estimate Lomax’s share price under the assumptions that the draft financial
statements are published as they are presently stated and that they are adjusted
to reflect the 15 year useful life for the manufacturing rights. State any
additional assumptions made. [10]
(iii) Discuss the suggestion that Lomax’s share price will be increased if the
company revises the expected useful life of the manufacturing rights. [5]
[Total 20]

20 Sally has been offered a business opportunity. Her brother Tom is about to go to
university and will need to earn a living over the next three years. He has been
offered the opportunity to buy a motorboat for £21,000. If Sally buys this boat then
Tom will offer fishing trips for clients at weekends. Tom is qualified to operate a
small boat that carries paying passengers and there is plenty of demand for this
service in their home town.
Tom proposes that he and Sally should prepare an annual income statement and split
the cash surplus for the year equally on the last day of each business year, after
leaving £2,000 in the business bank account to allow for working capital needs. The
motor boat will be scrapped at the end of the third year and the business will be
wound up.
Tom knows that Sally cannot afford to invest in this proposal unless it offers an
acceptable rate of return. He proposes that she evaluates this opportunity on the basis
that she will only invest if it offers her a minimum annual return of 12%.
Sally is interested in this proposal, and has decided to evaluate it in some detail. Her
one major concern is that the government is considering changing the law. If they do
so, then Tom’s business will probably lose its operating licence with the boat
becoming worthless. Tom has assured her that he took account of this risk and has
already factored it into his suggested return of 12%, which is why he has not
suggested a lower rate.
Tom has provided Sally with the following projected income statements:
Year ended Year ended Year ended

30 June 30 June 30 June
2015 2016 2017
£ £ £
Revenue (all cash sales) 40,000 50,000 60,000

Fuel, boat repairs and mooring (all cash) (14,000) (17,500) (21,000)
Depreciation (7,000) (7,000) (7,000)
19,000 25,500 32,000
(i) Calculate the net present value of Sally’s cash flows and comment on the
results. [8]
(ii) Explain how Sally might use certainty equivalents to evaluate Tom’s proposal.
[6]
(iii) Discuss the argument that the risks of legal changes should be dealt with by
setting a slightly higher discount rate. [6]
[Total 20]
END OF PAPER
CT2 A2014–8
EXAMINERS’ REPORT

Core Technical
Introduction
D C Bowie
June 2014

Subject CT2 (Finance and Financial Reporting Core Technical) – April 2014 – Examiners’ Report
The general performance was similar to results in the past; well-prepared candidates scored
where candidates could have improved their performance. Candidates are advised to include
these areas in their revision. The main problems were Q19 and 20; however many candidates
scored high marks in all questions.
1 A
2 C
3 B
4 C
5 D
6 D
7 C
8 B
9 C
10 C
6 11.6% = (17 × 10/25) + (8 × 15/25)

14% = (17 × 30/45) + (8 × 15/45)
14.27% = (17 × 30/45) + (7 × 15/45)
14.55% = (17 × 48/66) + (8 × 18/66)
8 £1.8m = 30% × £6m

£2.4m = 30% × £8m
9 €150,000 = €950,000 – 850,000

€200,000 = cancelled depreciation
€350,000 = €950,000 – (800,000 – 200,000)
€750,000 = €950,000 – 750,000
Generally questions 1–10 were answered reasonably well by most candidates.
11 The value of the debt will depend on the likelihood that the company will meet its
commitments to pay the interest and the capital. The decline in the equity shows that
the market believes that the company is less profitable. That loss appears to have
been borne by the shareholders only, whose equity acts as a safeguard to protect the
lenders. The shareholders are entitled to all residual profits and so any setback will
affect their future cash flows. The lenders do not receive any benefit from the entity’s
profit, at best they will receive their agreed payments on time. Thus, the lenders are
not necessarily affected in the same way as the shareholders.
The lenders may have taken care to impose an upper limit on borrowing so that there
is very little realistic probability of their repayments being affected .
This question was not done especially well. Some answers were very confused and it was not
clear exactly what was meant in their answer. Some candidates did not discuss the lenders at
all.
Page 3
12 Ron will be able to buy the shares at a discount and resell them immediately for their
full market price.
If Ron invests in his employer then he may be motivated and take a greater interest in
his work.
It sounds as if Ron may not have a properly diversified portfolio. The markets will
not reward him for retaining the diversifiable unsystematic risks. Furthermore, in the
event that the company declines Ron may lose both his job and his investment, so he
is even more exposed to the company’s performance.
Ron may be better placed as an employee to determine whether Global is performing

well and so he may be able to mitigate these risks by being sufficiently well informed
to sell before information becomes generally available. The observations of
individual employees are unlikely to comprise insider trading.
13 It would be impractical to permit depreciation as a taxable expense because of the

discretion that is available in estimating the charge. The owner could easily
manipulate depreciation in order to reduce profits or avoid making large tax losses.
The tax authorities would be unable to do very much to prevent such behaviour
provided the rates being used for depreciation could be justified.
It is incorrect to say that no benefit is given. UK tax law gives a capital allowance in
lieu of depreciation. Capital allowances are essentially just depreciation that has been
determined in a very consistent and systematic manner.
This question had a mixed response from candidates with many candidates failing to mention
capital allowances or the possibility of manipulating depreciation.
14 Seven shares held before the issue will be worth 7 × £5.20 = £36.40.
The new project will increase market capitalisation by 20%, so seven shares will
increase in value to £36.40 + 20% = £43.68.
The cash injection will add a further £4.50 per seven shares
= £43.68 + £4.50 = £48.18.
Each share will be worth £48.18/8 = £6.02.
This question was done well by many candidates.
Page 4
15 The scrip issue offers the investor a choice between £0.50 cash and
2 × £2.70/9 = £0.60 of equity. At face value, the scrip dividend appears more value,
although there will be some dilution. Transaction costs will probably mean that it is
not cost-effective to take the scrip dividend with a view to the immediate resale of the
shares.
The investor will have to pay tax on the scrip dividend but there is no cash coming in
and so this will have to be settled out of existing cash balances.
The shareholder will have to consider whether the scrip issue will leave the portfolio
unbalanced.
16 Very few assets have free and transparent markets that make it possible to observe fair
values. Fair values generally require subjective decisions, perhaps based on
transactions that are not necessarily indicative of the values that would be obtained for
a particular asset. For example, the fair value of an office block could be estimated
using selling prices for similar offices in similar locations, but those will not
necessarily establish the actual price that will be obtained for a specific building.
Transactions used for comparison may be slightly out of date. Comparisons may be
based on transactions that are not at arm’s length.
Ultimately, an asset’s fair value can only be established by actually putting the asset
up for sale and waiting until a firm offer to buy it has been received.
This question had a mixed response. Some candidates did this well and others badly.
Application of knowledge seemed to be the main problem.
17 The IASB develops high quality accounting standards (IFRS). IFRS provide a basis
for comparison between companies, with consistent treatments of similar items.
Thus, the IASB promotes confidence in the financial statements.
The IASB also demonstrates the accountancy profession’s commitment to ensuring

high quality accounting statements. There have been issues in the past with concerns
about accounting scandals and the IASB’s existence is clear evidence that such
behaviour cannot be tolerated.
The IASB’s standards facilitate global investment and trading.
Page 5
18 The going concern concept effectively requires consideration of the long-term future.
A company’s ability to survive may depend on many different factors, each of which
is very difficult to predict. For example, the market for the entity’s products could
decline or there could be a problem with cash flows and the availability of finance to
deal with that.
Another difficulty is that preparers will only ever be challenged when the company
has actually run into difficulties. Users of financial statements may claim that the
going concern status was inappropriate on the basis of actual outcomes rather than
expectations based on the information that was available at the time. Many users,
such as buyers, will place a great deal of emphasis on going concern.
This question was done very badly by most candidates. Candidates could briefly quote what
the going concern concept was but then stopped. There was a lack of ability to apply
knowledge from the core reading to a question.
19 (i) EBITDA = 58.2 + 62.0 + 40.0 = £160.2m
Analysts are generally concerned that any subjective decisions will be used to
manipulate the financial statements. The figure for EBITDA excludes two of
the biggest sources of subjectivity in the financial statements: depreciation and
amortisation.
It may be difficult to restate figures to make these comparable. For example,

Lomax’s accounting policy on depreciation does not make it possible to
establish whether the company is more or less conservative than similar
businesses.
Analysts prefer pre-tax figures because those are generally more comparable
with other income sources, and it avoids the subjective estimate of the tax
liability.
(ii) Book value of rights 360,000,000

Amortisation based on 15 years 24,000,000
Increase in earnings 16,000,000
Revised earnings attributable to the shareholders 49,500,000

Revised EPS 0.99
Expected share price based on present 10.72

Expected share price based on revised 15.84
We are assuming the straight line basis for the amortisation of the intangible.
We are assuming that the P/E ratio of 16 is robust and that the market will
multiply the earnings figures by 16.
We are assuming that the P/E ratio will not change during the period from 31
March 2014 until the date when the financial statements will be published.
Page 6
That assumption implies, further, that nothing in the financial statements

themselves will affect the market’s view of future cash flows.
(iii) The share price is determined in terms of future cash flows. The amortisation
of an intangible asset is not a cash flow and so the figure has no direct
relevance to determining the share price.
The capital markets might be influenced by the information implied by

management estimates. Extending the projected life of the asset may imply
that additional costs will not be incurred in developing new products and so
the share price might increase.
The capital markets might interpret these changes as evidence that Lomax’s
directors feel that it is necessary to overstate accounting profits. That might
lead to a decrease in confidence and a decline in the share price.
Part (i) – This question was not done very well, many candidates could attempt the
calculation but did not answer the written part well. It seems that candidates have the
knowledge from the core reading but have difficulty applying it in some of these questions.
Part (ii) – This part of the question was done reasonably well by some candidates but many
candidates did not achieve a high mark in this section of the question.
The calculation was done quite well by a number of candidates but many candidates did not
state their assumptions.
Part (iii) – This part of the question was done badly as candidates could not apply the
knowledge learned from the core reading material.
20 (i)
Year ended Year Year ended

30 June ended 30 30 June
2015 June 2016 2017
£ £ £
Revenue 40,000 50,000 60,000
Fuel, boat repairs (14,000) (17,500) (21,000)
and mooring
Working capital (2,000) 2,000
24,000 32,500 41,000
Sally's share 12,000 16,250 20,500
Discount factor 0.893 0.797 0.712
PV 10,716 12,951 14,596 38,263
The net present value of Sally’s cash flows = £38,263 – 21,000 = £17,263
Sally should accept this project on a net present value basis. This is a major
investment for her, though, and so it may not be appropriate to risk such an
amount.
Page 7
(ii) The first step would be for Sally to estimate how much she would accept as a
guaranteed sum in place of each of the cash flows in her forecast. For
example, she anticipates a cash inflow of £12,000 at the end of year 1. That
amount is subject to the risks associated with the running of the business and
so it would be logical for her to accept less in return for a guarantee that the
lesser sum would be paid. The estimates that she uses will be highly
subjective and they really have to be decided by her, although she might start
by considering the likely ranges of outcomes and taking those into account.
She might also consider her need for cash inflows at each of those dates.
Once she has determined the certainty equivalents then they should be
discounted at a risk-free rate. The 12% rate includes an element to
compensate for the risks attached to the project.
S (iii) Tom is clearly attempting to make the project appear more attractive so that
Sally will invest.
This project involves Sally risking a significant part of her wealth, more than
she can afford to lose. She needs to evaluate the risk on the basis that the
change in the law might lead to the boat being scrapped as worthless before
she has received any revenue from the project. She should actually decide on
the basis of a discount rate that ignores the possibility of the change in the law.
She should then make a subjective decision as to whether that revised net
present value is sufficient incentive to risk the loss of her savings.
It might be appropriate to adjust the discount rate for a decision maker who
has a large number of projects to consider. That would mean that the “all or
nothing” aspect of these risks would not apply because of the portfolio effect.
Part (i) – This question was done badly with very few candidates making a good attempt.
Part (ii) – This part of the question was done very badly. Very few candidates made a
reasonable attempt at this question and many missed it out. Those who did attempt the
question found it very difficult to clearly express an answer and even more just wrote a brief
explanation of certainty equivalents. It is important to think of application of knowledge when
revising.
Part (iii) – Unfortunately this part of the question was not done well. Again it seems to be an
area where candidates found it difficult to apply knowledge learned from the core reading.
Page 8
EXAMINATION

Core Technical
booklet.
supervisor.
question on a new page.
question paper.

correct.
1 When considering the maximisation of shareholder wealth, how is shareholder wealth

expressed?
A directors’ estimates
B share price
C share price and dividends
D surveys of shareholders
[2]
2 A company has issued £0.25 shares at a premium of £0.20 per share. The
shareholders have each paid £0.22 for each share that they hold. What is the
maximum liability that each shareholder might bear with respect to each share in the
event that the company cannot pay its liabilities?
A £0.03
B £0.20
C £0.23
D £0.25
[2]
3 A UK taxpayer has disposed of four assets during the year. Which of the following
gains could be subject to Capital Gains Tax?
A The taxpayer purchased a large sum of Euros for use on holiday, which were
not spent and were worth more than had been paid for them when converted
back to Sterling.
B The taxpayer had invested in shares issued by his employer and sold them at a
gain.
C The taxpayer purchased a rare model of sports car, but sold it soon afterwards
at a profit because he found it difficult to drive.
D The taxpayer sold his family home, realising a profit, in order to move to a
smaller property.
[2]
CT2 S2014–2
4 A UK taxpayer has earned income in Australia and has paid tax to the Australian tax
authorities equivalent to £10,000. Under UK tax law the income would have been
subject to tax of £8,000. Which of the following is most likely to apply?
A The taxpayer can reclaim the whole of the tax paid in Australia.
B The taxpayer can offset the £10,000 paid in Australia against the total tax
liability arising in the UK.
C The taxpayer can offset £8,000 against the total tax liability arising in the UK.
D The taxpayer does not have to declare the income earned in Australia to the
UK tax authorities.
[2]
5 What is the most logical explanation for the requirement that investment income often
has tax deducted at source?
A To discourage companies from paying dividends.
B To ensure that taxpayers who have insufficient income to pay tax are required
to pay tax on their investment income.
C To enable governments to tax investment income at a higher rate than earned

income.
D To simplify the collection of tax.

[2]
6 A project that has been under review for some time has been modified so that the cash
receipts will remain the same, but their timing will be brought forward throughout the
length of the project. How will this affect the project’s internal rate of return and net
present value (using a positive risk discount rate)?
A The internal rate of return and net present value will both decrease.
B The internal rate of return and net present value will both increase.
C The internal rate of return will increase and the net present value will decrease.
D The internal rate of return will decrease and the net present value will increase.
[2]
7 Which of the following is NOT a potentially correct interpretation of a high gross

profit percentage?
A The entity has negotiated high selling prices.

B The entity has negotiated low cost prices.
C The entity is overcharging its customers.
D The entity is undercharging its customers.
[2]

8 A company’s earnings before interest and tax is £400,000. It has one million £1
shares in issue, fully paid, and retained earnings of £800,000. Long term liabilities
are £500,000. What is the entity’s return on capital employed?
A 17.4%
B 22.2%
C 26.7%
D 30.8%
[2]
9 How will the components of the return on capital employed ratio be affected if a
company charges depreciation too slowly?
A Return will be understated and capital employed will be overstated.

B Return will be overstated and capital employed will be overstated.
C Return will be overstated and capital employed will be understated.
D Return will be understated and capital employed will be understated.
[2]
10 Which of the following best explains why liquidity ratios based on a company’s
published accounts are unlikely to be useful for credit control purposes?
A The figures are likely to be based on historical costs.

B The figures are likely to be inaccurate.
C The figures are likely to be manipulated by creative accounting.
D The figures are likely to be out of date.
[2]
11 Explain why the market prices of shares are generally regarded as unbiased reflections
of the shares’ “true” value. [5]
12 Discuss the circumstances in which non-recourse factoring might be an appropriate

means of obtaining finance. [5]
13 A company has five years left to run on a variable rate loan which it has issued. It has
been suggested that it would be possible to enter into a swap in order to achieve the
effect of converting this to a fixed rate loan. The directors are concerned that the
counterparty might not honour the terms of the swap arrangement and leave the
company’s liabilities unpaid.
Discuss the directors’ fears with respect to the risks arising from the potential default
by the counterparty. [5]
CT2 S2014–4
14 A quoted company’s shares have a nominal value of £0.25 per share. The shares have
been trading at prices between £0.40 and £0.43 per share for almost two years. The
shareholders are concerned that the share price is not growing. The directors wish to
raise further equity by means of a rights issue in order to invest in new projects, but
informal discussions with shareholders suggest that a rights issue would be unpopular.
One of the directors has suggested a scrip issue in order to boost shareholder
confidence in the hope that a rights issue would then be more likely to succeed.
Set out the advantages and disadvantages of the director’s suggestion. [5]
15 A company requires all proposals for investment projects to be supported by a net

present value calculation. One of the directors has suggested that proposals should
also indicate opportunity costs.
Discuss the advantages and disadvantages of the director’s suggestion. [5]
16 Discuss the potential advantages and disadvantages of using probability trees for the
evaluation of long term projects. [5]
17 Discuss the ways in which the external auditor adds credibility to a company’s
published financial statements. [5]
18 Discuss the potential risks and benefits associated with having very rapid receivables
and inventory turnover ratios. [5]

19 Trevor and Simone have taken early retirement. Their retirement package has left
each of them with a lump sum that is substantial, but they have decided to start a
business together in the hope of accumulating significant wealth before reaching
normal retirement age in eight to ten years.
They have identified an opportunity to import consumer electronics from the Far East.
They have established that there is a substantial niche market in the UK for products
such as mobile phones and tablet computers that are produced for the Chinese market
and which are rarely exported.
Trevor and Simone have negotiated the exclusive UK rights to import a new line of
products that is presently in the final development stage. They have a few months to
establish their company and to ensure that all of their distribution lines are in place.
Their retirement payments will only provide approximately 60% of their funding
requirements. They are unsure whether to raise additional funds by inviting investors
to become minority shareholders in this venture, or to seek a bank loan, or a
combination of the two.
(i) Discuss the relative merits of the bank loan or additional equity from minority
shareholders for Trevor and Simone’s company. [10]
(ii) Discuss the difficulties associated with determining the optimal gearing level
for Trevor and Simone’s company. [10]
[Total 20]
CT2 S2014–6
20 Victor Ltd manufactures office equipment.
Prepare the following financial statements for the year ended 31 August 2014:
• an income statement
• a statement of financial position
• a statement of changes in equity
The following trial balance has been extracted from Victor Ltd’s bookkeeping
records:
Trial Balance as at 31 August 2014
£000 £000
Administrative expenses 4,500
Audit fee 3,780
Bank 11,340
Debenture loan (8%) 43,470
Debenture loan interest 1,740
Dividend paid 3,240
Factory – cost 100,440
Factory – depreciation 19,008
Inventory at 1 September 2013 2,160
Manufacturing equipment – cost 90,504
Manufacturing equipment – depreciation 25,920
Manufacturing overheads 3,606
Purchases 27,000
Revenue 108,000
Wages – administration 1,944
Wages – manufacturing 11,772
Wages – sales 12,384
283,482 283,482
1. Closing inventory was counted on 31 August 2014 and was valued at £675,000.
2. The debentures were issued in 2011 and are repayable in 2022. The interest for
the period from 1 March 2014 to 31 August 2014 was paid in September 2014.
3. Depreciation has still to be charged as follows:
• factory – 2% of cost
• manufacturing equipment – 25% reducing balance

4. The following expenses have to be accrued:
• wages (split equally between administration, manufacturing

and sales) £9,000
• administrative expenses £40,000
Manufacturing overheads includes insurance that has been prepaid by £10,000.
5. A tax expense of £4,190,000 has to be provided for.

[20]
END OF PAPER
CT2 S2014–8
EXAMINERS’ REPORT

Core Technical
Introduction
The report is written based on the legislative and regulatory context at the date the
examination was set. Candidates should take into account the possibility that circumstances
may have changed if using these reports for revision.
F Layton
November 2014

subject for the first time are advised to concentrate their revision in these areas. The main
problem was Q19, however many candidates scored high marks in all questions.
Page 2
1 B or C were accepted as correct answers [2]

2 C [2]
3 B [2]
4 C [2]
5 D [2]
6 B [2]
7 D [2]
8 A [2]
9 B [2]
10 D [2]
Workings
2 £0.03 = £0.25 – 0.22

£0.20 = premium
£0.23 = £0.25 + 0.20 – 0.22
£0.25 = nominal value
8 17.4% = 400,000/(1,000,000 + 800,000 + 500,000)

22.2% = 400,000/(1,000,000 + 800,000)
26.7% = 400,000/(1,000,000 + 500,000)
30.8% = 400,000/(800,000 + 500,000)
Questions 1–10 were done well by most candidates. No particular question caused a
problem for candidates.
11 Market prices are based on actual transactions, so market participants are actually
entering into transactions at these prices. Most quoted securities tend to trade quite
freely, so market prices are also likely to be quite up to date. The fact that these prices
are observable also means that they can be legitimated, unlike other valuations that
are likely to be based on models or opinions. The objectivity associated with market
prices means that they are likely to be acceptable to, say, tax authorities. [5]
This question was not specifically looking for a discussion of market efficiency, but an
answer based on the efficient markets hypothesis would be perfectly acceptable.
This question was done well by candidates.
Page 3
12 Non-recourse factoring is only worthwhile if an entity makes significant credit sales.

The entity will also be looking to release cash from its trade receivables, which
suggests that it might be in need of improving cash flows. Non-recourse factoring
usually involves a range of additional services, such as bookkeeping as well as credit
protection. There is very little point in paying for non-recourse factoring unless there
is a need for those services. The factor will only be willing to offer non-recourse
factoring if the customers are reasonably good credit risks. [5]
This question was done reasonably well by many candidates. The only problem was that
several candidates did not appear to understand the difference between factoring and non-
recourse factoring and their answer was therefore not clear.
13 Swap arrangements do not involve the actual exchange of liabilities. The two parties
usually arrange a net payment from one to the other, depending on the rates paid on
the variable rate liability. In the worst possible case, the party that is due to receive a
net payment will lose this amount because the counterparty defaults. The other risk is
that any default will leave both parties without the protection of fixed or variable rate
interest, which was the purpose of the swap in the first place. Both parties should take
the usual precautions of running credit checks. Sometimes the counterparty will be a
commercial bank rather than another business and so there will be a better basis for
trust. [5]
14 The expectation is that the scrip issue will be interpreted as a sign of confidence and
so the share price will increase. That only happens in practice because the directors
often maintain the dividend per share after a small scrip issue and so it might be
viewed as a signal that the board intends to increase dividends. Given that the
shareholders appear to lack confidence, they are unlikely to boost the share price just
because of a scrip issue.
The issue would dilute the existing share price, which could disrupt the share price.
Fresh shares cannot be issued for any less than the nominal value of £0.25 per share.
A significant scrip issue could leave the share price so close to the nominal value that
there is very little scope for offering the discount that is necessary to guarantee the
success of the issue. [5]
This question was done very well.
Page 4
15 Opportunity costs should be taken into account, particularly when projects are
mutually exclusive or there is capital rationing. When accepting one project means
that it would be impossible to proceed with another then the board should consider
whether the project under consideration is the best use of the entity’s funds.
Opportunity costs can be difficult to determine. It is necessary to identify all of the

alternative uses to which those funds can be applied or to identify all of the projects
that would be rendered redundant. It may be difficult for the managers who are
making the proposal to be aware of those implications, especially when the projects
are not directly drawn from the bidding department.
It may be a little naïve to expect the champions of one project to be clear and honest
about another project’s opportunities. [5]
16 Probability trees make it easy to determine the expected value of a complex project
that has various levels of decision that have to be taken. Different branches of the tree
will deal with the possibilities that were identified at the outset of the project and so
the decisions that will be appropriate at each stage of the project can be identified well
in advance and an appropriate direction selected. Decision trees generally offer a
clear and unambiguous solution to a potential problem.
On the other hand, expected values ignore the fact that many projects will not have an
“average” outcome. For example, a decision tree might suggest that a project has a
very small positive expected value when the actual outcome will either be a large
profit or a large loss. [5]
This question was done reasonably well by most candidates.
17 The external auditor offers an opinion on the fair presentation/truth and fairness of the
financial statements. That gives the shareholders the reassurance that the figures have
not been manipulated or distorted in a manner that would make them misleading. The
audit opinion is based on the collection of evidence on the accuracy of the
bookkeeping records. Auditors are qualified accountants who are experts in financial
reporting matters. The auditor’s reputation will be impaired if an invalid or
unsupported opinion is offered. [5]
This question was not done as well as expected. In general many answers were vague and
did not answer what was asked in much detail.
Page 5
18 The upside risk is that very little cash will be tied up in working capital. Cash flows
will be rapid and so the entity should be reasonably sound in terms of liquidity.
Reducing inventory can be achieved through careful management and monitoring.

Such an approach creates a cost in terms of the time spent managing inventory and
also having to incur ordering costs from placing a larger number of smaller orders.
The alternative is that the entity simply runs inventory down to such a low level that it
runs out, possibly losing sales and disrupting operations. Reducing receivables
usually requires pressing for rapid payment, which may also reduce demand if
customers are keen to obtain a more lenient set of credit terms. [5]
This question was done well by many candidates. The main problem with candidates who did
less well was a failure to discuss inventory in any detail.
19 (i) Debt has the advantage of interest payments being tax deductible. Lenders
usually have quite a lot of security, so they charge a reasonably low rate.
This business may make many lenders nervous. It is a new venture that may
not prove successful because it is selling a niche product that is untried in the
UK. The assets will be in the form of inventories of products that could be
difficult to sell quickly in the event of a foreclosure.
In the event that the business succeeds it may find cash flows problematic.
Imports are likely to be for cash and sales are likely to be on credit, which will
stretch working capital and that may make it difficult to service debt.
Equity will be relatively expensive because potential investors may be nervous

about the business plan. They may require a considerable percentage of the
equity to make the risk worthwhile. Trevor and Simone may find it difficult to
retain full control if they wish to attract investors.
The fact that the founders wish to retire for good in the medium term future
may deter many potential investors. If the business succeeds then the other
shareholders may be unable to raise sufficient cash to buy Trevor and Simone
out and so they may be faced with the loss of control to a new set of investors.
[10]
(ii) There is likely to be an optimal level of gearing because our two founders are
unlikely to be able to create their own gearing, which is the basis of the MM
irrelevance argument. Ideally, the gearing level should be sufficient to get the
best of the lower gross cost and the tax relief compared to the higher cost of
equity.
Trevor and Simone will be relatively risk averse because their life savings are
being invested in this business. They cannot really afford to risk liquidating
the business in order to settle overdue loan repayments. That suggests that
benchmarks, such as the gearing ratios of similar businesses in the same line
may not be particularly appropriate.
Page 6
The fact that this is a new business that is selling products that are, by
definition, unproven makes it more difficult to predict the cash flows from
which debt can be serviced. The founders must also allow some of their debt
capacity to remain unused so that they have a source of cash to deal with
emergencies. They do not have any cash of their own left over in order to
inject further equity.
Lenders may offer guidelines as to the maximum that they will be prepared to
advance, but that does not help Trevor and Simone because the lenders will be
banking on the protection offered by the buffer of the founders’ equity.
The fact that there are only two principal decision-makers also complicates
matters. Trevor and Simone may have different risk tolerances and each may
have a different view about the ideal level of gearing.
[10]
[Total 20]
This question was unfortunately done very badly by a number of candidates. Candidates
struggled to say much about debt and equity and financing and then candidates did not write
much at all about gearing. Many candidates did not understand that having two decision
makers complicated the situation. Candidates did not think through what they had learned
and apply it to this particular scenario successfully so many did not do well in this question.
The problem seemed to be that applying knowledge to this scenario was difficult for
candidates.
Page 7
20 Victor Ltd
Income Statement for the year ended 31 August 2014
Revenue 108,000
Gross profit 45,989
Selling and distribution (12,387)
Administrative expenses (10,267)
Finance charge (3,480)
Profit before tax 19,855
Tax expense (4,190)
Victor Ltd
Statement of Changes in Equity for the year ended 31 August 2014
Equity Retained Total

shares earnings
£000 £000 £000
Opening balance 60,480 23,760 84,240
Dividend (3,240) (3,240)
Closing balance 60,480 36,185 96,665
Page 8
Victor Ltd
Statement of Financial Position as at 31 August 2014
£000

Current assets
Inventory 675
Prepayment 10
Cash 11,340
21,097
Total assets 148,958
Equity
96,665
Debentures 43,470
Current liabilities
Accruals 1,789
Tax payable 4,190
8,823
148,958
Note: Non-current assets
Page 9
Factory Property, Total

plant and
equipment
£000 £000 £000
Cost 100,440 90,504 190,944

Depreciation
Opening balance 19,008 25,920 44,928
Charge for year 2,009 16,146 18,155
Closing balance 21,017 42,066 63,083
Net book value 79,423 48,438 127,861
Workings
Cost of sales
Opening inventory 2,160
Purchases 27,000
Wages – manufacturing 11,772
Closing inventory (675)
Factory depreciation 2,009
Equipment depreciation 16,146
Accrued wages 3
Prepaid insurance (10)
62,011
Selling and distribution

Wages 12,384
Accrued wages 3
12,387
Administrative expenses
Trial balance 4,500
Audit fee 3,780
Wages 1,944
Accrued wages 3
Accrual 40
10,267
Accruals
Wages 9
Administration 40
Accrued interest 1,740
1,789
[20]
Question 20 was done really well by most candidates. This contributed to the very good pass
rate for this diet. It was evident that candidates had spent time learning this topic and it paid
dividends as the marks were very high for this question.
Page 10
EXAMINATION
28 April 2015 (pm)

Core Technical
booklet.
supervisor.
4. Attempt all 20 questions. Answers to questions 1-10 should be indicated on the Multiple
Choice Answer Sheet included in your booklet. From question 11 onwards begin your
answer to each question on a new page.
question paper.
CT2 A2015  Institute and Faculty of Actuaries

correct.
1 Which of the following best explains what is meant by the “Euro” prefix in
Eurobonds?
A The bonds are denominated in Euros.

B The bonds are issued offshore, outside of legal or tax jurisdictions.
C The bonds are issued only in Europe.
D The bonds are regulated under European law.
[2]
2 Which of the following is NOT a disadvantage of issuing preference shares?
A Preference dividends can be suspended at the directors’ discretion.
B Preference dividends do not offer tax relief.
C Preference shares increase the gearing ratio.
D Shareholders have to be offered a higher rate than would be paid on an

equivalent loan.
[2]
3 Why might a company choose to attach a warrant to a bond issue?
A Bondholders might accept a lower rate of interest in the expectation of a

capital gain.
B Bondholders are attracted by the additional protection offered by a warrant.
C Warrants reduce the tax payable by the company.
D Warrants dilute shareholder returns.

[2]
4 An investor is considering the purchase of a 2% Treasury Bill that is trading at a

discount. Which of the following statements is correct?
A The rate of return on this investment is equal to 2%.

B The rate of return on this investment is greater than 2%.
C The rate of return on this investment is less than 2%.
D The rate of return on this investment cannot be predicted.
[2]
CT2 A2015–2
5 A new machine will cost a company £700,000 and will increase profits by £180,000
per year. The machine will be depreciated over ten years.
What is the payback period on this machine?
A 2 years and 10 months

B 3 years and 11 months
C 6 years and 4 months
D 10 years exactly
[2]
6 Which of the following best describes the need for the consistency concept in
financial reporting?
A All similar transactions should input into the bookkeeping records in the same
way throughout the accounting period.
B Financial statements prepared by an entity should be comparable from year to

year.
C Financial statements prepared by different entities should be comparable.
D The users of financial statements should use consistent criteria for interpreting
accounting information.
[2]
7 A company’s trade receivables owed £200,000 at the beginning of the year and
£250,000 at the end. Cash sales were £900,000 and credit sales were £1,700,000.
How much cash was collected from customers during the year?
A £1,650,000
B £2,550,000
C £2,600,000
D £2,650,000
[2]
8 A business had assets at the beginning of the year worth £700,000 and liabilities
worth £240,000. At the end of the year assets were worth £910,000 and liabilities
were worth £260,000. The owners have not invested any equity and have received no
dividend. What profit did the company make during the year?
A £190,000
B £210,000
C £230,000
D £650,000
[2]

9 Which group of users will be most interested in the fair value of a company’s non-
current assets?
A business contacts
B employees
C lenders
D shareholders
[2]
10 An 80% controlling interest was acquired in a subsidiary company when it had equity
shares with a book value of £800,000 in issue and retained earnings of £600,000. The
book value of the subsidiary’s equity shares remain unchanged but retained earnings
are now worth £900,000. What value should be attributed to the non-controlling
interest in this subsidiary?
A £60,000
B £180,000
C £280,000
D £340,000
[2]
11 In many countries capital gains are only taxed when the taxpayer disposes of the asset
on which the gain has arisen.
Describe the implications of delaying the taxation of capital gains until the asset has
been sold. [5]
12 Describe the advantages and disadvantages of issuing debenture stocks in order to

raise finance. [5]
13 A software development company is considering raising funds to expand the business.

The company’s only significant asset is the office block that it uses to accommodate
its programming and administrative functions.
Explain the potential implications of raising funding through a sale and leaseback
arrangement on the company’s office block. [5]
14 A quoted company has had a difficult year and the directors believe that it may be too
risky to maintain previous levels of dividend. However, they are considering
maintaining the dividend in order to preserve stock market confidence.
Describe the implications for the directors of maintaining the dividend in these
circumstances. [5]
CT2 A2015–4
15 An investor maintains a balanced portfolio of shares. She tends to favour low beta
securities. She was concerned to discover that the beta of a particular share that she
has held for many years has increased over the past year.
Explain why a beta value might change. [5]
16 An investment project involves an initial investment, followed by five years with net
cash inflows and a sixth year with a net cash outflow because the site used for the
project will have to be repaired.
The project’s internal rate of return (IRR) has been calculated. There are two internal
rates of return: 2% p.a. and 9% p.a.
Explain how a project could have two internal rates of return and how this will affect
the decision to accept or reject the project. [5]
17 An airline has been offered the opportunity to purchase an international express

delivery company. The delivery company operates in the same countries as the
airline. The airline’s directors are considering this investment on the grounds of
“strategic fit”, even though the investment appears to have a negative net present
value.
Describe the arguments for using strategic fit to justify this investment. [5]
18 Describe the importance of the standards set by the International Accounting

Standards Board (IASB). [5]

19 The directors of Vapor receive a set of financial statements every month for
discussion at their regular board meetings. The report for the month of February has
just been prepared, along with comparative figures for the month of January.
Income statements for the month of:
February January
£000 £000
Revenue 900 700

Cost of goods sold (368) (175)
532 525
Operating costs (240) (250)
Profit for the month 292 275
Statements of financial position at the end of:
February January
£000 £000
Current assets
Inventory 32 220
Trade receivables 1,010 720
Cash 12
1,042 952
2,940 2,452
Equity
Share capital 1,000 1,000
2,384 2,092
Current liabilities
Cash 371
556 360
2,940 2,452
During February, Vapor paid £400,000 for an item of equipment. The payment was
funded using a bank overdraft as a temporary measure. Vapor will take out a
£400,000 long term loan in May.
February’s revenue includes a £200,000 sale to a registered charity at cost price.

Apart from supporting the charity’s work, this sale generated some valuable publicity
for the company.
CT2 A2015–6
Vapor’s directors receive a short table of accounting ratios to accompany their
monthly financial statements. The production director has suggested that this table
should be extended to include the figure for return on capital employed. The finance
director has replied that the return on capital employed ratio should not be calculated
on a monthly basis, but should be monitored annually.
(i) Calculate the following ratios for January and February, making appropriate
adjustments to the figures in respect of the information provided concerning
the purchase of the new equipment and the sale to the charity:
 gross profit margin

 current ratio
 trade receivables turnover in days
 trade payables turnover in days
[8]
(ii) Explain the reasons for the adjustments that you made in part (i) in respect of
the information provided concerning the purchase of the new equipment and
the sale to the charity. [6]
(iii) Discuss the finance director’s argument that the return on capital employed
ratio should be reviewed annually, but not monthly. [6]
[Total 20]

20 Exesses is a family-owned company that is in the process of recovering from a major
corporate scandal. Exesses is a substantial business that is not quoted. None of its
shareholders owns more than 5% of the equity shares. None of the shareholders is
able to take an active role in the company’s management.
Exesses’ directors were all forced to step down because of the discovery that the
directors had been overstating reported profits, which had the effect of inflating their
profit-related bonuses. The directors also provided themselves with lavish lifestyles
at the company’s expense. For example, the company provided chauffeur-driven
limousines to transport the directors on both business and personal travel.
The entire board of Exesses has resigned. The shareholders have met and have
appointed a new chairman and a chief executive. Neither of these appointees have
had anything to do with Exesses in the past. They have both agreed that their first
priority is to appoint a new board and to structure the management arrangements so
that the shareholders’ confidence is restored.
The chairman has suggested that the new board should be structured as follows:
 The chairman will work on a part-time basis and will be responsible for the
management of the board, including chairing board meetings. The chairman will
be paid a fixed annual salary that offers an appropriate rate for the time that he is
expected to commit to the company.
 The chief executive will be employed on a full-time basis to manage the company
itself and will receive both a substantial salary and a profit-related bonus.
 Four additional full-time directors will be appointed to take charge of particular

areas such as marketing and finance. Each will receive a similar package to the
chief executive.
 Two part-time directors will be appointed to participate in board meetings and to

review corporate strategy. They will be paid a fixed salary.
 The chief executive and each of the full-time directors will receive a 5%
shareholding after satisfactorily completing three years on Exesses’ board.
 The chairman and the two part-time directors will appoint a new external audit
firm. They will negotiate a contract with a much larger firm than the outgoing
auditor and will pay a larger fee for the new auditor’s services.
(i) Discuss the suitability of the proposals for the appointment and remuneration
of the new board of directors from the perspective of maintaining shareholder
confidence. [12]
(ii) Discuss the implications of appointing a larger and more expensive external
audit firm to replace the present auditor. [8]
[Total 20]
END OF PAPER
CT2 A2015–8
EXAMINERS’ REPORT

Core Technical
Introduction
The report is written based on the legislative and regulatory context at the date the
examination was set. Candidates should take into account the possibility that circumstances
may have changed if using these reports for revision.
F Layton
June 2015

problems were Q15, 16, 19 and 20, however many candidates scored high marks in all
questions.
Page 2
1 B
2 A
3 A
4 B
5 A
6 B
7 B
8 A
9 C
10 D
Workings
5 2 years 10 months = £700,000/(180,000 + 70,000)

3 years 11 months = £700,000/180,000
6 years 4 months = £700,000/(180,000 – 70,000)
10 years = asset life
7 £1,650,000 = £200,000 + 1,700,000 – 250,000

£2,550,000 = £200,000 + 1,700,000 + 900,000 – 250,000
£2,600,000 = 1,700,000 + 900,000
£2,650,000 = £200,000 + 1,700,000 + 900,000 + 250,000
8 £190,000 = (910,000 – 260,000) – (700,000 – 240,000)

£210,000 = 910,000 – 700,000
£230,000 = (910,000 + 260,000) – (700,000 + 240,000)
£650,000 = 910,000 – 260,000
10 £60,000 = 20% × (900,000 – 600,000)

£180,000 = 20% × 900,000
£280,000 = 20% × (800,000 + 600,000)
£340,000 = 20% × (800,000 + 900,000)
Questions 1–10 were done reasonably well by most candidates, no particular question
caused problems.
Page 3
11 The most immediate implication is that the taxpayer has a much greater degree of
control over the timing of tax payments. Tax can be delayed indefinitely simply by
retaining the asset. Sales can be timed to make the best possible use of any tax
allowances.
Taxpayers do not need to pay tax until they are raising cash from the disposal of the
asset. That avoids having to be forced to sell an appreciating asset in order to raise
cash to pay tax on the capital gains.
The gain is based on an actual transaction, so it can be determined with greater

accuracy.
The tax system may deter the disposal of assets because of the need to pay tax on the
gain arising from a disposal.
12 Debentures are generally secured against assets, with the debenture holder being paid
before virtually any other creditor. That level of security means that the debenture
holder does not need to receive a very high rate of interest.
It may be necessary to seek permission from the debenture holder before an asset that
has been pledged can be sold.
There is very little prospect of flexibility in the event of a problem. The debenture
holder will have the right to force the sale of the assets that form the security and so
any cash flow problems could prove catastrophic.
13 The lessor now owns the building and so runs very little risk in the event that the
software company defaults on the rent payments. That makes this a relatively
inexpensive financing package for the software company.
The software company will no longer benefit from any capital appreciation on the
office building. Presumably the lessor will be able to increase rents over the long-
term if property prices rise.
This is the software company’s only real asset. It now has nothing to pledge as
security in the event of raising further funds at some future date.
Page 4
14 There is a risk that the company will find itself in difficulty if it has insufficient cash
left after the dividend payment. The shareholders may question the wisdom of paying
the full dividend in these circumstances and so the directors may simply appear
reckless.
The payment of a dividend is generally regarded as a fairly robust sign of confidence.

If the directors believe that the company can afford the dividend then it may reassure
the shareholders.
The fact that the directors are generally reluctant to reduce the dividend payment
means that any reduction or suspension will be seen as convincing evidence that the
company is in trouble. There may be a disproportionate reduction in the share price.
15 The beta value is basically determined by regressing returns on a security against

those from the market as a whole. There is no real reason to believe that the beta will
remain constant from period to period. Different market conditions may affect the
return on the security in different ways and so changes in, say, interest rates may
affect the security more than, say, changing currency values.
If investors are attracted by particular systematic risk profiles then that could affect
the demand for a security and even that could alter the beta to some extent. Strong
demand could drive up share prices regardless of the market situation and that could
raise or lower the beta.
This question was not done well. Few candidates demonstrated more than basic knowledge
of betas. The marks were quite low with many candidates scoring less than half marks. In
the past questions on beta have been done well so this was surprising. Very few candidates
had any knowledge of systematic risk.
16 The fact that there are two periods with net outflows can create the possibility of a
second IRR. If discount rates are very small then the cost incurred at the conclusion
of the project will have much greater significance and that could be enough to make
the net present value negative.
This project has a positive NPV when the required rate of return is greater than 2% or
less than 9%. There is not a single hurdle rate, but the cost of capital can be related to
the IRR in the same manner as for any other project.
It is unlikely that the company will be looking for a return of less than 2%, so this
project appears to be worth accepting provided the company is willing to accept a
return of 9% or less.
This question was done badly.

Few candidates demonstrated reasonable knowledge of IRR or NPV. Few candidates
commented on the hurdle rate.
Page 5
17 Strategic fit can be thought of as a non-monetary benefit that can be obtained from an
investment. The fact that the project is a good fit with the business means that it may
create future opportunities for expansion or it may reduce certain risks. The fact that
this company is operating flights between a number of countries may make it ideally
suited to exploit synergies such as using surplus space on aircraft to carry freight.
These opportunities might be difficult to foresee at the evaluation stage of the project
and they will be lost if the company does not take the occasional chance on an
opportunity that may yield dividends.
18 Accounting standards make accounting statements far more credible. Shareholders

have the means to specify the manner in which the figures are determined and so have
a better understanding of the figures prepared by the directors.
Mutual understanding of the figures will reduce contracting costs. Lenders can
specify debt covenants in terms of accounting numbers with no real concern that the
directors will manipulate accounting numbers in order to reduce, say, the gearing
ratio.
Accounting standards provide auditors with the basis for checking the fair
presentation of the financial statements.
19 (i) It could be argued that the assets and liabilities in respect of the charity
transaction should be excluded from the calculation of the current ratio.
February January
Gross profit margin 532/(900  200) = 76% 525/700 = 75%
Current ratio (1,042 + 29)/185 952/360 = 2.6:1
= 5.8:1
Trade receivables 1,010/900 × 31 720/700 × 31
turnover = 35 days = 32 days
Trade payables 185/(368 – 200) × 31 360/(175 + 200) × 31
The table above shows the most likely versions of the acceptable answers.
The following alternatives are acceptable:
February January
Trade receivables 1,010/900 × 365/12 720/700 × 365/12
Trade payables 185/(368  200) × 28 360/(175+200) × 31
Trade payables 85/(368 200) × 365/12 360/(175+200) × 365/12
Page 6
(ii) The £200,000 of sales at cost should be excluded from February’s turnover,
otherwise the directors will not be comparing like with like – January’s
percentage will be made up entirely of normal trading activity and February’s
will be a weighted average of trade sales and a major transaction with a zero
gross profit.
The £400,000 which has been paid for the new fixed asset should be excluded
from the bank overdraft. This will increase the bank balance to +£29,000.
This is because the liability is not really part of the normal overdraft and will
be replaced by a term loan.
(It might also be argued that the assets and liabilities relating to the “charity”
transaction should be excluded on the grounds that this is non-recurring and
has a distorting effect. The difference here is that the company does actually
have to finance these assets and settle the liabilities under normal trade
terms.)
(It might also be argued that the purchases figure can be best estimated by
adding the cost price of the charity sale to January’s cost of sales and
subtracting from February’s. The figures suggest that the company has built
up inventory in January in advance of this sale.
(iii) ROCE cannot really be calculated with any great accuracy for a period as
short as one month. The company might not make really accurate adjustments
for stocks as at the beginning and end of each month, monthly depreciation
charges, accruals and prepayments, etc.
If the company has any kind of annual business cycle then the directors might
get the mistaken impression that a month has been poor because of
fluctuations in return (as sales rise and fall) or capital employed (as net assets
change during the year).
While ROCE is the most important profit ratio, it is quite possible that it
would be far more sensible to concentrate on the secondary ratios such as
gross profit %, asset turnover, etc.. If these are maintained during the year
then the company should generate an acceptable return over the course of a
year.
Part (i) – this part was answered badly with many candidates failing to calculate the ratios
correctly which was disappointing. Even gross profit was problematic.
Part (ii) – unfortunately this part was answered badly with few candidates suggesting the
correct adjustments.
Part (iii) – candidates did not demonstrate much knowledge of ROCE. The comments tended
to be very basic and just commenting on it being a measure of profitability. As a result of this
the marks were quite low for this section of the question.
Page 7
20 (i) Having two different people head the company offers a degree of mutual
oversight. The chairman and chief executive can be responsible for different
aspects of the management of the company.
The chairman and the part-time directors do not benefit when the company
reports higher profits and so they have no great incentive to misbehave. They
are likely to insist that the company is properly managed because their
reputations will be at risk for no purpose if they do not.
The full-time directors are all to receive profit-related bonuses. That will give
them an incentive to work in the best interests of the shareholders. The risk of
a repeat of the previous difficulties will be diminished because of the oversight
from the chairman and part-time directors.
The chairman and part-time directors can monitor the company’s activity for
lavish and unnecessary expenditure. They should have sufficient business
experience to realise the difference between legitimate expenses and
extravagances such as the limousines.
The fact that the full-time directors stand to share in a substantial shareholding
is a further incentive to work in the shareholders’ interests. These shares will
be far more valuable if the directors can work towards the maximisation of the
share price. The shareholders will, hopefully, have greater confidence because
of this. Furthermore, the three year vesting period provides the directors with
an incentive to settle with the company and offer continuity of management.
That period is also quite a long time in which to evaluate the directors’
competence and integrity.
Note: answers could refer to the requirements of the UK Code for Corporate
Governance or similar documents, but there was no need to do so in order to
obtain credit.
(ii) Given the problems with the overstated profits in the past it is clearly
undesirable to continue with the previous auditor. The shareholders
are unlikely to have a great deal of confidence in the outgoing firm.
A larger audit firm may be more credible. It has more to lose in terms
of its reputation and so the auditor may be less willing to compromise
over accounting issues
The fact that the audit fee is greater may also create the impression that
more work has been done or that the audit has been more thorough.
Shareholders may contrast the fee with that charged by the previous
auditor and may perceive the increase as an investment in higher
quality.
All auditors have the same professional qualifications and so there is

no guarantee that a bigger firm will necessarily provide a better quality
service. The higher cost of a bigger firm may not be justified in terms
of the actual assurance given.
Page 8
Part (i) – this part was also answered quite badly. Candidates did not demonstrate
knowledge of corporate governance issues. However, many candidates gave good answers
about maximising shareholder wealth and confidence which helped increase the pass rate.
Part (ii) – answers to this part of the question were mixed. There were some very good
answers but also some poor ones.
Page 9
1
2 INSTITUTE AND FACULTY OF ACTUARIES
3
4
5
6
7
EXAMINATION
8
9 9 October 2015 (am)
10
11 Subject CT2 – Finance and Financial Reporting
12 Core Technical
13
14
15
16
17 1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
18
19 supervisor.
20
21
4. Attempt all 20 questions. Answers to questions 1–10 should be indicated on the Multiple
22
23 answer to each question on a new page.
24 5. Candidates should show calculations where this is appropriate.

25
26 Graph paper is NOT required for this paper.
27
28 AT THE END OF THE EXAMINATION
29 Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
30
31 In addition to this paper you should have available the 2002 edition of the Formulae
32
33
34 CT2 S2015  Institute and Faculty of Actuaries
35
1 Which of the following best describes the par value of an equity share?
A The market value of a quoted company’s shares.
B The price at which the share could be sold in an arm’s length transaction.
C The value attached to the share for bookkeeping purposes.
D The value that would be attributed to the share for tax purposes in the event
that it is sold.
[2]
2 Which of the following best describes the relationships between the interests of major
groups of stakeholders in a limited company?
A The directors will ensure that all stakeholders’ interests are satisfied.
B The stakeholders’ interests will often conflict and their relationships will be
defined entirely by formal, written contracts.
C The stakeholders’ interests will often conflict and their relationships will be
defined by a combination of contracts and implicit agreements.
D The stakeholders will work together for their mutual benefit.

[2]
3 An investment opportunity involves the purchase of a machine for $40,000. The

machine will have a useful life of five years, after which time it will be scrapped. The
machine will increase reported profit by $11,000 every year for five years. The
company uses straight line depreciation. The required rate of return is 8% per annum.
The investment will be funded by a loan for five years with an interest rate of 6% per
annum.
Calculate the net present value of this investment.
A $3,923
B $6,332
C $35,867
D $40,028
[2]
CT2 S2015–2
4 A company has evaluated a large and complex investment proposal using Monte
Carlo simulation. The simulation suggests that there is a 10% probability of a
negative net present value, a 60% probability of a small positive net present value and
a 30% probability of a substantial positive net present value.
How should these results be interpreted?
A The actual outcome will be within the upper and lower limits arising from the
simulation.
B The average outcome calculated from these figures shows how the project is
likely to turn out.
C The project should proceed because there is only a 10% probability of a loss.
D The range and frequency of the expected outcomes provide a broad indication
of risk.
[2]
5 What is the most logical interpretation of a very small positive net present value
determined for an investment proposal?
A The internal rate of return should be calculated in order to determine whether

that provides further information.
B The investment should only be considered if it also has a very short payback.
C The project offers slightly more than the required rate of return and so it is
worth considering.
D The project should be disregarded because the small net present value means
that it is not worth pursuing.
[2]
6 Why are preference shares normally treated as debt when calculating the gearing
ratio?
A Preference shares affect the volatility suffered by ordinary shareholders.
B Preference shares can sometimes be classified as debt in the financial

statements.
C Preference dividends can be suspended.
D Preference shares can be redeemable.

[2]

7 Which of the following best explains why investment analysts often use earnings
before interest, tax, depreciation and amortisation (EBITDA) as a performance
measure?
A EBITDA is a more objective measure than profit for the year.
B EBITDA is a more realistic measure of overall performance than profit for the
year.
C EBITDA is likely to be greater than profit for the year.
D EBITDA is likely to be smaller than profit for the year.

[2]
8 A company’s directors are considering manipulating their current ratio by delaying

the payment of trade payables, that would normally occur before the year end, until
some time after the year end. Which of the following statements is correct?
A If the company has a bank overdraft and a current ratio of more than 1:1 then
the current ratio will be increased by this delay.
B If the company has a bank overdraft and a current ratio of more than 1:1 then
the current ratio will be reduced by this delay.
C If the company has a positive bank balance and a current ratio of less than 1:1
then the current ratio will be increased by this delay.
D If the company has a positive bank balance and a current ratio of more than
1:1 then the current ratio will not be increased by this delay.
[2]
9 Which of the following best describes the role of International Financial Reporting
Standards (IFRS) in the situations in which they are applicable?
A IFRS eliminate inconsistency in accounting choices.

B IFRS ensure consistent disclosure across all companies.
C IFRS prevent misleading financial reporting.
D IFRS provide guidance on the appropriate treatment of specific matters.
[2]
CT2 S2015–4
10 Which of the following best explains what it means when the external auditor issues a
disclaimer of opinion?
A The auditor disagrees with the figures prepared by the directors.
B The auditor is satisfied that the financial statements give a true and fair view.
C The auditor is unable to express an opinion on the truth and fairness of the
D The auditor wishes to withdraw an opinion that has previously been reported.
[2]
11 Describe the relationship between principals and agents according to agency theory.
[5]
12 Modigliani and Miller argue that gearing is irrelevant, but this argument depends in
part on the fact that investors can borrow in order to invest in shares issued by
companies that are under geared.
Discuss the extent to which personal gearing can be a realistic substitute for corporate
gearing. [5]
13 Discuss the potential advantages and disadvantages of using a finance lease to acquire
an asset rather than borrowing the cost of the asset in order to purchase it outright.
[5]
14 Discuss the difficulties faced by underwriters in setting an appropriate fee in respect

of an offer for sale at a fixed price. [5]
15 Banks typically receive deposits on which variable rates of interest are offered.
Explain why a bank may use interest rate swaps in managing the cost of interest. [5]
16 Describe ways in which governments can use taxation to incentivise pensions saving.
[5]
17 Describe one technique that company directors could use to manipulate their
company’s reported earnings (a practice that is sometimes referred to as “creative
accounting”). [5]
18 Discuss the proposition that none of a company’s profitability ratios matter provided
the return on capital employed ratio is satisfactory. [5]

19 Global plc is a quoted company that manufactures petrochemicals. The company has
recently patented a new process that will enable it to extract oil from oilwells that had
previously been regarded as uneconomic.
Global plc is confident that the process is fully protected by patent law, so that
nobody else can use it without permission. The directors have demonstrated the
process to business and oil industry journalists and to television news stations and it
has generated a great deal of publicity. Global plc’s directors were disappointed that
there was very little evidence of an increase in the share price in response to this
positive publicity. The process had been a closely guarded secret before the
announcement, and nobody outside the company knew that a major project was under
development.
(i) Discuss the directors’ belief that Global’s share price should have increased
upon the announcement of the new process. [8]
The directors are considering how best to exploit this new technology. One
possibility would be to buy oil exploration rights and to hire the necessary equipment
and expert staff to explore for oil. Global plc could then use the process to extract oil
from any wells that it drills. The other possibility would be to sell the right to use the
process to oil companies under licence. These rights could be valuable to oil
companies and so Global plc could charge a great deal for them.
Global plc’s directors have estimated potential cash flows from both exploring for oil
and for selling licences. They will compare the two in terms of their net present
values. With that in mind, they have obtained the following information concerning
beta coefficients:
 Global plc’s own beta coefficient is 1.3
 an oil exploration company has a beta of 0.8
 a product-design company that specialises in environmentally sustainable

developments has a beta coefficient of 1.0
(ii) Evaluate the suitability of each of the beta coefficients identified by Global’s
directors as a basis for deciding whether to pursue one of the alternatives for
exploiting the new process. [12]
[Total 20]
CT2 S2015–6
20 Maxload Ltd is a manufacturing company. Prepare the following financial statements
for Maxload Ltd for the year ended 31 August 2015:
(i) Statement of Profit or Loss [10]

(ii) Statement of Financial Position [8]
(iii) Statement of Changes in Equity [2]
[Total 20]

£000 £000
Administrative staff salaries 2,680
Cash at Bank 4,580
Directors' salaries 4,200
External audit fee 3,620
Loan interest 4,000
Long term loan 45,000
Plant and equipment – cost 90,410
Plant and equipment – depreciation 48,530
Production staff wages 10,870
Property – cost 98,000
Property – depreciation 14,560
Purchases 82,500
Revenue 147,800
Sales staff commission 5,200
Sales staff salaries 11,850
354,770 354,770
1. The closing inventory was £3,770,000.
2. Sales staff commission of £720,000 was earned during the year ended
31 August 2015, but not paid until September 2015.
3. Depreciation has still to be recorded on the following basis:
Property – 2% straight line

Plant and equipment – 25% reducing balance
4. Directors’ bonuses of £2,000,000 have still to be paid.
5. A tax expense of £5,600,000 has been estimated for the year ended
31 August 2015.
END OF PAPER
CT2 S2015–7
EXAMINERS’ REPORT
September 2015

Core Technical
Introduction
The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.
The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.
For numerical questions the Examiners’ preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.
The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.
F Layton
December 2015

A. General comments on the aims of this subject and how it is marked
1. The aim of the Finance and Financial Reporting subject is to provide a basic
understanding of corporate finance including a knowledge of the instruments used by
companies to raise finance and manage financial risk and to provide the ability to interpret
the accounts and financial statements of companies and financial institutions.
2. This paper examines basic finance including raising funds by a variety of methods,
taxation, net present value and project appraisal and other topics, it has both calculations
and essay type questions on these topics. The paper also examines financial reporting
including preparation of the main financial statements and interpretation of financial
statements it also considers the basis of the preparation of statements and the
information needs of a variety of end users of financial statements.
3. Different numerical answers may be obtained to those shown in these solutions

depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be
penalised where excessive rounding has been used or where insufficient working is
shown.
B. General comments on student performance in this diet of the

examination
problem was Q19, however many candidates scored high marks in all questions.
C. Comparative pass rates for the past 3 years for this diet of examination
Year %
September 2015 64
April 2015 61
September 2014 60
April 2014 54
September 2013 57
April 2013 66
Reasons for any significant change in pass rates in current diet to those in the
past:
The pass rate for this examination diet is slightly higher than the April 2015 rate, but not
materially different. Variation in the pass rate between sessions is expected as different
cohorts of students sit the examination.
Page 2
Solutions
Q1 C
Q2 C
Q3 C
Q4 D
Q5 C
Q6 A
Q7 A
Q8 C or D was accepted
Q9 D
Q 10 C
Workings:
Q3 Net profit discounted at 8% = $11,000  3.993 – 40,000 = $3,923

Cash flow discounted at 8% = $19,000  3.993 – 40,000 = $35,867 (Correct)
Net profit discounted at 6% = $11,000  4.212 – 40,000 = $6,332
Cash flow discounted at 6% = $19,000  4.212 – 40,000 = $40,028
Questions 1–10 were done well by most candidates. No particular question

caused a problem for candidates.
Q11 Principals are often forced to appoint agents to make decisions on their behalf.
The agents’ economic interests may be in conflict with those of the principal.
Principals may be exposed to losses because their delegation of authority and control
may mean that they fear that the agents will also control the information at their
disposal to monitor them. The agents could, for example, overstate performance in
order to retain their jobs or increase their bonuses. The fear of manipulation may lead
to costly and restrictive monitoring activities. Agency costs could also reduce market
prices.
Q12 Personal gearing can enable the shareholders to obtain the effect of a lower cost of
Capital from borrowing and they can invest the proceeds in equity shares to get the
additional return. This will not be a perfect substitute. The shareholders are unlikely to
obtain the same low rate that could be obtained by the company. Furthermore,
corporate gearing permits the shareholders to enjoy limited liability. Personal gearing
would leave the shareholders personally liable. They may also wish to leave their
personal borrowing capacity free for personal purposes. Tax is also an issue. The
Page 3
company can claim interest as an expense for tax purposes, whereas the shareholders
cannot.
This question was done very badly by candidates who did not understand
what personal gearing was and had difficulty coming up with any sensible
solution to the question.
Q13 Finance leases may be attractive to lenders because they automatically provide a
degree of security. The lessor retains ownership of the asset and so it will be
relatively easy to take possession of it in the event that the lessee runs into financial
difficulty. The lessor’s security may result in a lower finance charge than would be
the case with a standard term loan. The lessee can structure the lease in a manner
that fits with its requirements and can cease to be responsible for the asset from the
conclusion of the lease. Having said that, the lease arrangement may prove
inflexible. If, say, the lessee wishes to replace the asset then it may be more difficult
to do so. The lessor would be entitled to insist on the lease commitment being
honoured, whereas an asset that has been purchased outright can be sold and the
proceeds used to offset the outstanding loan. The lessee benefits from the fact that
the lessor is protected and can charge a lower rate.
Some candidates discussed tax issues and creative accounting issues which
was excellent, these points are not covered in core reading but candidates
were awarded marks for these points. This question was answered well.
Q14 The fact that the shares are unquoted means that the outcome of the offer may be
difficult to predict. The underwriter has to ensure that the risks of bearing significant
losses from any failure in the offering are adequately priced. The risks could arise
from unexpected quarters, such as economic news that depresses markets generally.
Fresh information could also emerge from the due diligence associated with the
floatation. The underwriter must ensure that a realistic fee is charged, bearing in
mind that there is a market and that overpricing could result in the loss of the
business.
This question had a mixed response with some very good answers and some
poor ones.
Q15 Banks generally have a specific advantage with respect to raising variable rate finance
(if bank deposits are viewed as loans) . Banks often attract significant amounts of
variable rate debt and would often prefer to convert some of that to fixed rate. A
portfolio of fixed and variable rate will leave the bank less exposed to movements in
interest rates. Furthermore, many of the bank’s financial assets will take the form of
fixed-interest loans to customers and so there could be a mismatch between assets and
liabilities. Swaps enable them to make best use of their specific advantage and to
Page 4
convert some of that to fixed rate to the mutual benefit of the bank and the
counterparty.
This question was answered badly with many candidates showing no

knowledge of swaps.
Q16 Tax relief on contributions makes it cheaper for individuals to save for retirement
through pensions. There may also be a less onerous rate of tax on the pension
income after retirement. Taxpayers on higher rates will often find these tax benefits
to be of particular value because the tax subsidy should be proportionately greater
for them.
Companies might also receive tax relief on the payments they make towards
providing for pensions.
The pension scheme may not be taxed on its investment income in the same way that
another investor would.
Pensioners may be permitted to take out tax-free lump sums.
This question was not answered well with many candidates ignoring many of
the taxation implications.
Q17 The key to creative accounting is that the rules appear to have been complied with
even though the figures are potentially misleading. One approach that may be taken
could be the aggressive manipulation of estimates. For example, the depreciation
charge requires an estimate of the lives of property, plant and equipment. The
company could appear to charge the correct amount of depreciation by overstating
expectations, while remaining within the limits of credibility. The directors could
argue that any subsequent correction arising from the disposal of the assets was due
to a misunderstanding.
Any form of creative accounting was awarded marks, many candidates

answered this question very well.
Q18 Return on capital employed determines whether the profit justifies the funding tied up
in the business. If the ROCE is acceptable then the shareholders should be satisfied
that the company is earning sufficient profit to enhance their wealth. The other
profitability ratios can be viewed as secondary, in the sense that they provide insight
into the ROCE. The fact that ROCE is acceptable does not mean that the shareholders
and managers would be willing to forego any potential improvement. For example,
the gross profit percentage could indicate that the company could change its trading
strategy in order to further increase gross profit and so enhance ROCE. Ratio analysis
Page 5
is a complicated undertaking and so it would be very short-sighted to rely on a single

ratio.
Q19 (i) The share price is effectively the net present value of anticipated cash flows. A
fresh investment should create the expectation of further cash flows and so the
share price should increase.
In practice, though, the markets may anticipate investment in capital projects.

Sophisticated investors may have taken the possibility of a degree of
investment in new projects into account when making the buy/sell decisions
that determine the share price. This new project could simply confirm an
expectation that had already been built into the share price.
It is also possible that the market may not agree with the directors’ optimism.
Commercial sensitivity may mean that the shareholders are not given full
disclosure of expected returns and future cash flows. That would mean that the
shareholders would be unlikely to have the same confidence as the directors.
The shareholders may feel that the risks are greater than the director’s claim
because the directors will benefit in the short term from appearing to have
made an astute investment.
(ii) An asset’s beta coefficient reflects the systematic risks of that asset. Specific
risks are diversified away, leaving the volatility of returns in the asset relative
to the volatility of returns on the market rate as a whole.
Global’s own beta would be relevant if the systematic risks affecting the
project are the same as those affecting Global as a whole. It is unlikely that this
project would have the same risk characteristics as the company because the
two entities operate at different stages in the business cycle. If the price of oil
rises then that may be adverse from the point of view of most market
participants and so capital markets may decline. Global buys oil and so it may
be affected in the same way as the market. The new investment is likely to be
more attractive when the price of oil increases because it will enable Global’s
licensees to extract more oil that is now more valuable. Beta can also be
affected by capital structure and so we may have to adjust for Global’s gearing
ratio.
The oil exploration company’s beta may be less than 1.00 because it is more
affected by unsystematic risks such as whether it strikes oil. The industry is
potentially capital intensive and so interest rates may have a large part to play in
the company’s exposure to systematic risks. The price of oil could also affect
the company’s performance and an increase in oil prices would be desirable
from the company’s point of view. It is difficult to decide how that links the
new venture’s performance to that of the business. Interest rates are unlikely to
affect the new venture, although oil prices will. Using a beta of less than 1.00
Page 6
also implies a low cost of capital, which may have the effect of making
Global’s board appear a little reckless.
The product design company may have some aims in common with Global’s
new venture because both are about making the best use of available
resources. Having said that, the product-design company is unlikely to have
the same exposure to systematic risk as the new venture. The use of a beta of
1.00 would suggest that the company is as volatile as the market a whole. That
may prove to be a defensible argument to use with respect to this new venture.
Part (i) – Some candidates gave a reasonable answer to this section although
may candidates made a poor attempt.
Part (ii) – This part of the question was done very badly as candidates did not
understand systematic risk at all. Very few candidates discussed the oil
industry in any depth.
Q20 Maxload Ltd

Statement of Profit or Loss for the year ended 31 August 2015
£000
Revenue 147,800
Gross profit 36,260
Finance charge (4,000)
Tax expense (5,600)
Loss for the year (3,610)
Page 7
Maxload Ltd
Statement of Changes in Equity for the year ended 31 August 2015
Equity Retained
shares earnings Total
£000 £000 £000
Opening balance 75,000 21,180 96,180

Loss for the year (3,610) (3,610)
Dividend (15,000) (15,000)
Closing balance 75,000 2,570 77,570
Maxload Ltd
£000
Current assets
Inventory 3,770
Bank 4,580
20,700
Equity
77,570
Loan 45,000
Current liabilities
Accruals 2,720
Tax 5,600
11,020
133,590
Page 8
Note
Non-current assets
Plant and
£000 £000 £000
Cost 98,000 90,410 188,410

Depreciation
Opening balance 14,560 48,530 63,090
Charge for year 1,960 10,470 10,470
Closing balance 16,520 59,000 75,520
Net book value 81,480 31,410 112,890
Workings
Cost of sales
Purchases 82,500
Closing inventory (3,770)
Property depreciation 1,960
Plant and equipment
depreciation 10,470
111,540
Sales staff commission 5,200
Accrued commission 720
17,770
Administrative staff salaries 2,680
Directors’ salaries 4,200
External audit fee 3,620
Directors’ bonuses 2,000
12,500
Accruals
Sales staff commission 720
Directors’ bonuses 2,000
2,720
Page 9
This question was done very well by many candidates with some scoring full
marks. It was excellent to see so many really good attempts.
Page 10
1
3
4
5
6
7
EXAMINATION
8
9 14 April 2016 (am)
10
12 Core Technical
13
14
15
16
booklet.
18
19
supervisor.
20
21
22 4. Attempt all 20 questions. Answers to questions 1–10 should be indicated on the Multiple
23 answer to each question on a new page.
24 5. Candidates should show calculations where this is appropriate.
25
27
30 question paper.
31
32 and Tables and your own electronic calculator from the approved list.
33
34 CT2 A2016  Institute and Faculty of Actuaries
35
1 What is the defining characteristic of a Eurodeposit?
A A currency deposited in Europe.

B A currency deposited in the European Union.
C A currency deposited outside its country of origin.
D A deposit denominated in a European currency.
[2]
2 Which of the following describes an over the counter security?
A A security that is created by a recognised exchange.

B A security that is issued by a retail bank.
C A standardised instrument that is traded on the markets.
D A tailored instrument whose terms are agreed between the counterparties.
[2]
3 Why might an overdraft be the cheapest way to fund working capital requirements?
A Banks can call in overdrafts without notice.

B Banks offering overdraft facilities are in competition with one another.
C Overdrafts attract a relatively low rate of interest.
D The entity’s funding needs are fluctuating.
[2]
4 Why might a share buyback increase a company’s share price?
A A share buyback is a sign of confidence on the part of the board.

B Buybacks do not involve any transaction costs.
C The buyback returns funds that were not generating an acceptable return.
D There are no taxes payable on buybacks.
[2]
5 An investment project is to be evaluated on the basis of a real rate of return. What

does that mean for the evaluation of the project?
A Inflation should be ignored in predicting cash flows.

B Inflation should be included in the predicted cash flows.
C It is less likely that the project will be selected.
D It is more likely that the project will be selected.
[2]
CT2 A2016–2
6 A company’s share price has a beta of close to zero. How should that be interpreted?
A Beta cannot be zero, so the figure has been calculated incorrectly.

B The company is not sensitive to the factors that affect the market generally.
C The company’s shares would make an unattractive investment.
D There is no risk associated with investing in that company.
[2]
7 A company’s beta coefficient is 1.6 and it has a 30% gearing ratio. How would beta
change if the corporation tax rate increased?
A Any change in beta would depend on the market’s reaction.

B Beta would decrease.
C Beta would increase.
D Beta would remain the same.
[2]
8 An oil company has used a probability tree to evaluate the risks and benefits
associated with drilling for oil at each of four potential locations. The probability tree
shows that drilling on site Y has a positive expected net present value of $100m,
which is greater than those for sites W, X or Z. How should this be interpreted?
A Drilling at site Y will definitely generate future net cash inflows of $100m.
B The oil company should definitely drill at site Y.
C The probability tree outcomes should be considered before making a decision.
D The probability tree provides an objective basis for reaching a final decision.
[2]
9 Risk averse individuals often buy lottery tickets despite the fact that the expected
value of doing so is negative. What does this reveal?
A These individuals are behaving in an irrational manner.
B The certainty equivalent of a slim chance of winning a major prize exceeds the
cost of a lottery ticket.
C The certainty equivalent of a slim chance of winning a major prize is smaller

than the cost of a lottery ticket.
D Lottery contestants do not understand basic probability theory.

[2]

10 Which of the following reflects the relationship between a parent and an associate
company?
A The parent and the associate are linked through a joint venture.
B The parent and the associate trade with one another.
C The parent can control the associate.
D The parent can influence the management of the associate.
[2]
11 Describe the role of tax in determining whether an individual shareholder would

prefer to receive a dividend or a capital gain. [5]
12 Describe the advantages and disadvantages to existing shareholders of funding

expansion using convertible loan stock. [5]
13 A family company has grown to the point where it might be considered for a stock
market quotation.
Describe the advantages and disadvantages to the present shareholders of seeking a

quotation. [5]
14 Suggest possible reasons why acceptable gearing ratios often vary between countries.
[5]
15 Many organisations require the evaluation of a project appraisal report to be

documented. Explain the purpose of this documentation. [5]
16 A leisure company is considering building and operating a theme park.
Describe the process of conducting a simulation of this investment as part of the

evaluation of this project. [5]
17 Describe the importance of the cash flow statement. [5]
18 Explain the relevance of the balance on a company’s revaluation reserve to its

shareholders. [5]
CT2 A2016–4
19 The directors of Gryffe have been approached by Subb, a potential customer who
wishes to seek a substantial trade credit facility. Subb is a small company, but it is a
member of the Parrent Group, a major corporation.
Gryffe’s accountant has ascertained the following:
x Subb was founded seven years ago. It has grown slowly but steadily ever since.
x Parrent purchased its 40% holding of Subb’s equity two years ago. The terms of
the agreement reached with Subb’s existing shareholders are that Parrent will
have the right to appoint a number of directors to Subb’s board.
Subb’s chief buyer has submitted the latest financial statements of both Subb and the
Parrent Group. Subb’s financial position appears to be rather weak, but the Parrent
Group is large, profitable and liquid. The chief buyer’s covering letter indicates that
Gryffe should evaluate the application for trade credit on the basis of Parrent’s
consolidated financial statements. Subb’s chief buyer also asks that attention be paid
to the external auditor’s report in both sets of financial statements because the auditor
has issued an unmodified report in both cases.
Gryffe’s directors have asked for an explanation as to why Subb can claim to be part
of the Parrent Group when Parrent is a minority shareholder.
(i) Describe the factors that would indicate whether Subb is, indeed, a member of
the Parrent Group. [5]
(ii) Explain the suitability of the Parrent Group’s consolidated financial

statements for the purpose of determining whether Gryffe should advance
trade credit to Subb. [5]
(iii) Explain the relevance of the external auditor’s report to Gryffe in deciding
whether to grant trade credit to Subb. [5]
(iv) Recommend, with reasons, safeguards that Gryffe could put in place to
manage the security of the receivable due from Subb in the event that it grants
Subb’s request. [5]
[Total 20]

20 Jute is an actuarial consultancy that has three departments: Pensions, Insurance and
Risk.
The following figures have been prepared for the year ended 31 March 2016.
Statements of Profit or Loss

For the year ended 31 March 2016
Pensions Insurance Risk TOTAL

£000 £000 £000 £000
Fees 11,000 9,000 3,600 23,600

Salaries (7,700) (5,400) (1,440) (14,540)
Depreciation – computers (667) (467) (200) (1,334)
Depreciation – premises (36) (36) (18) (90)
Other expenses (104) (104) (52) (260)
Interest (288) (288) (144) (720)
Profit 2,205 2,705 1,746 6,656
Statements of financial position

As at 31 March 2016
Pensions Insurance Risk TOTAL

£000 £000 £000 £000
Non-current assets
Office 1,800 1,800 900 4,500
Computers 2,000 1,400 600 4,000
3,800 3,200 1,500 8,500
Current assets
Unbilled hours 1,467 1,725 480 3,672
Trade receivables 642 675 150 1,467
Bank 250 175 65 490
2,359 2,575 695 5,629
Total assets 6,159 5,775 2,195 14,129
Equity
Share capital 800 800 400 2,000
Retained earnings 3,061 2,863 848 6,772
3,861 3,663 1,248 8,772
Mortgage on office 1,600 1,600 800 4,000
Current liabilities
Accrued salaries 642 450 120 1,212
Other creditors 56 62 27 145
698 512 147 1,357
Total of equity + liabilities 6,159 5,775 2,195 14,129
CT2 A2016–6
All staff time is billed to clients. Members of staff update a daily electronic
timesheet. Their employment costs for that day are charged to the client or clients for
whom they were working that day. Jute’s directors invoice clients for the time
charged to their accounts as and when they deem appropriate. The invoices are
charged at cost plus a markup to cover other expenses and profit.
Staff time is the only expense which is charged directly to contracts. All other
expenses are treated as overheads.
The company is based in a large office block which it owns. Pensions and Insurance
each occupy 40% of the floor space and Risk occupies 20%. Share capital and long
term loans are apportioned to the departments on the basis of these proportions.
Jute’s shares are all owned by the company’s founders, all of whom are directors.
The directors are concerned about the profit statement and statement of financial
position for the following reasons:
x Risk’s revenue and profit were much smaller than those of the other departments.
Jute’s directors are concerned that the Risk department could be undermining the
profitability of the company as a whole.
x Despite making substantial profits, Jute has very little cash available from which
to pay dividends or even to meet short term commitments. The company has not
been investing heavily in new fixed assets and has not made any loan repayments.
(i) Compare the profitability of Risk with that of the other departments,
explaining whether it is less profitable than the other two, and supporting your
answers with relevant ratios. [10]
(ii) Calculate:
(a) the average length of time taken for staff costs to be charged to a
client.
(b) the average length of time taken by clients to settle their invoices.
[2]
(iii) Assess why Jute appears to have run into liquidity problems. [4]
(iv) Suggest how Jute’s liquidity problems might be overcome. [4]

[Total 20]
END OF PAPER
CT2 A2016–7
EXAMINERS’ REPORT
April 2016 (with mark allocations)
CT2 – Finance and Financial Reporting

Core Technical
Introduction
exclusively.
F Layton
June 2016

statements it also considers the basis of the preparation of statements and the

calculations but candidates are not penalised for this. However, candidates may be
penalised where excessive rounding has been used or where insufficient working is
shown.

examination
problem was Q19, however many candidates scored high marks in most questions.
C. Pass Mark
The Pass Mark for this exam was 60%.
Page 2
Solutions
Q1 C [2]
Q2 D [2]
Q3 D [2]
Q4 C [2]
Q5 A [2]
Q6 B [2]
Q7 B [2]
Q8 C [2]
Q9 B [2]
Q10 D [2]
Questions 1–10 were done well by most candidates. No particular question

caused a problem for candidates.
Q11 Individuals have an annual allowance for capital gains, which means that some capital
gains are effectively tax free. [1]
Individuals usually pay tax at a lower rate on capital gains than on income. [1]
Capital gains are not taxed until the gain is realised. [1]
Thus, tax can be delayed by deferring the disposal of the shares until the taxpayer
requires the cash. [1]
Some taxpayers have very low incomes and will be able to offset dividends against
their personal allowances. [1]
Taxpayers will tend to gravitate towards companies whose dividend policies are
consistent with their tax preferences. [1]
[MAX 5]
Candidates did reasonably well in this question. The candidates had mixed
results with some doing very well and less prepared candidates doing very
badly.
Page 3
Q12 Existing shareholders may benefit from the fact that convertibles can offer lower
interest rates during the loan phase. [1]
That could be a permanent benefit in the event that the conversion is optional and the
lenders choose not to convert. [1]
The convertible may also be the only way in which the company will be able to attract
investment to fund a positive NPV project that will benefit the shareholders. [1]
The possibility of conversion also means that the company will not have to bear the
risk of being unable to raise sufficient cash to repay the loan. [1]
The disadvantage is that the conversion will almost certainly be on terms that are
advantageous to the lender. [1]
That is effectively a cost to the existing shareholders because their equity will be
diluted and their personal wealth will be reduced. [1]
[MAX 5]
Q13 The fact that the company is quoted means that it will find it much easier to raise
funds to expand. [1]
The shareholders will now have the means to liquidate their investments so that their
wealth is no longer tied up in the company. [1]
The stock market price will enable the shareholders to value their shares for tax
purposes in the event of, say, a gift of shares to a relative. [1]
The shareholders will have to sacrifice their control because of the need to sell shares
to a wider base. [1]
The company will also be subject to far greater scrutiny because of its quoted status.
[1]
Managerial decisions will be evaluated in terms of their impact on the share price. [1]
[MAX 5]
This question had the highest marks of all the short questions.
Q14 Business cultures vary with respect to borrowing. In some countries it is the norm to
seek equity funding whereas there is greater use of debt in others. [1]
Local shareholders will be nervous if a company exceeds the normal limits, but they
will also be dissatisfied if the opportunities afforded by debt are passed up due to
excessive reliance on equity. [1]
The fundamental difference is the attitudes of banks and other stakeholders. [1]
In some countries, the banks are tolerant of companies that are faced with temporary
difficulties with cash flow. [1]
Page 4
If the lender is likely to support a borrower through a difficult period then the
bankruptcy risks associated with gearing are reduced. [1]
The stability of the local economy is also an issue. [1]
If the local economy is steady then the volatility in operating profit that is accentuated
by gearing is less likely to occur. [1]
[MAX 5]
This question was done reasonably well by many candidates but there were
also some very weak attempts.
Q15 Investment analysis requires far more than a quantitative analysis such as the
calculation of NPV. Firstly, a number of assumptions have to be made in order to
determine future cash flows. [1]
Those assumptions must be made explicit and justified and the appraisal document
offers the opportunity to do so. [1]
Completing the document creates the framework for evaluating the project in a
systematic and disciplined manner. [1]
For example, there can be a formal requirement to evaluate risks and the project’s
strategic fit with the company overall. [1]
The document makes it far more difficult for the sponsors to present an optimistic and
one-sided analysis. [1]
The document will also assist with the project’s management because it will specify
various plans and objectives that can be used to measure progress once the project is
under way. [1]
[MAX 5]
Q16 The first step is to identify the variables that should be taken into account in the
simulation. [1]
For example, interest rates and other economic variables may affect consumer
spending and so those will have to be introduced as factors. [1]
Then the project’s cash flows will have to be modelled using estimates based on the
factors. [1]
An attempt will have to be made to determine how an increase in interest rates might
affect demand. [1]
This model will be complicated, otherwise there will be little point in using
simulation. [1]
The model should be run repeatedly until the average of the results obtained settle
down. [1]
The model can be run with different assumptions to determine which assumptions are
important in terms of the sensitivity of the results. [1]
Page 5
The results have to be analysed carefully because they will provide an indication of
the distribution of expected returns. [1]
The wider the disparity between best, worst and most likely returns the greater the risk
associated with this investment. [1]
[MAX 5]
This question was done badly with many candidates giving very short answers.
Q17 The cash flow statement indicates whether the entity is capable of generating cash
from its operations. [1]
In the short term, profit is not a good indicator of cash flow because there are so many
variables that can affect profit but not cash and vice versa. [1]
The company’s future could be in jeopardy if its cash is not properly managed. [1]
In the absence of a cash flow statement, the only measure of cash movements would
be the increase or decrease in the bank balance from one year end to the next. [1]
The cash flow statement provides a formal description of the cash inflows and
outflows, all linked to common themes such as investment activities. [1]
The shareholders can then see where the company is raising cash from and where the
resulting funds are being spent. [1]
[MAX 5]
This question was done badly by many candidates.
Q18 The revaluation reserve arises because book values have been revised upwards in
order to reflect the fair values of the company’s assets. [1]
The balance indicates that the figures in the statement of financial position are
potentially more relevant than if the assets had been left at cost less depreciation. [1]
While it may be argued that the entity has generated additional shareholder wealth
through holding the assets that have been revalued, the danger is that the gain has not
been realised. [1]
The shareholders cannot expect a fresh increase in the revaluation reserve to lead to an
increase in dividends. [1]
Indeed, the gains may have to be reversed in the future if market changes mean that
the fair values decline. [1]
The revaluation of property, plant and equipment may lead to greater subjectivity in
the financial statements. [1]
Page 6
That will extend to the statement of profit or loss because there will be additional
depreciation being charged. [1]
[MAX 5]
This question was done very badly by a significant number of candidates.
Q19 (i) The most important issue is whether Parrent can exercise control of Subb. [1]
Parrent will have to demonstrate that by showing that it can compel Subb to
behave in the manner that suit’s Parrent’s interests. [1]
The fact that Parrent does not own sufficient shares to exercise control is
irrelevant because control can be obtained through other means. [1]
In this case, Parrent can appoint board members to Subb’s board, which
implies the possibility of control. [1]
Presumably, there will be sufficient appointees to carry votes at board
meetings or the directors appointed by Subb will have enhanced voting rights.
The fact that Parrent can create consolidated financial statements that include
Subb indicates that it can exercise sufficient control to obtain the necessary
facts and figures. [1]
[Total 5]
(ii) Shareholders have limited liability. [1]

Parrent is no more responsible for Subb’s liabilities than any other shareholder
in the event of a default. [1]
If Subb is unable to meet its obligations then Parrent would be well within its
rights to leave Gryffe’s balance unpaid. [1]
It is debatable whether it would be in Parrent’s best interests to behave in this

manner. Firstly, permitting Subb to fail would probably mean that Parrent
would lose its investment and it would have to report a loss in its financial
statements. [1]
Secondly, the opportunity to participate in future profits from Subb would be
lost. [1]
Finally, Parrent’s reputation would suffer. [1]
[Max 5]
(iii) The external auditor reports on the truth and fairness (or fair presentation) of
the financial statements. [1]
That means that the statements offer stakeholders a credible basis upon which
to base decisions. [1]
The audit report makes no mention of the strength or security of the company
itself. [1]
It is for the readers to read and interpret the financial statements and to decide
how to behave. [1]
Page 7
The delays inherent in publishing financial statements means that the

information on Subb’s short-term liquidity will be out of date by the time that
the annual report becomes available. [1]
The external auditor will not accept any explicit responsibility towards the
users of the audited financial statements. [1]
The auditor will not, for example, compensate Gryffe if it suffers a loss
because of a bad credit decision. [1]
[Max 5]
(iv) The first step would be to request that Parrent grants Gryffe a formal guarantee
in support of Subb. [1]
That would mean that Gryffe would then have a legal right to pursue Parrent in
the event of any default by Subb. [1]
Gryffe may also attempt to reduce the risk of having to pursue Parrent for
payment. One approach to doing so would be careful credit control
procedures. [1]
All receivables should be monitored and slow payment investigated and
pursued. [1]
Slow payers could have their credit facilities suspended or even withdrawn. [1]
Gryffe could also set a credit limit, effectively restricting the maximum
exposure to loss in the event that Subb defaults. [1]
[Max 5]
[TOTAL 20]
This question was not done well. Parts (i) and (ii) were generally reasonably
well done, but parts (iii) and (iv) were done very badly. This resulted in many
candidates failing this question.
20 (i) Ratios
Pensions Insurance Risk

ROCE 2205/(3861+1600) = 40% 2705/(3663+1600) = 51% 1746/(1248+800) = 85%
Fees/salaries 11,000/7700 = 143% 9000/5400 = 167% 3600/1440 = 250%
Net profit % 2205/11000 = 20% 2705/9000 = 30% 1746/3600 = 49%
[1 mark per ratio – Max 5]
While Risk is the smallest department, it could be argued that it is the most
profitable.
The department’s return on capital employed is greater than either of the other
two. [1]
This means that the department produces more profit for every £ invested than
the others. [1]
(The very high ROCEs is not surprising given the nature of this business,
which is not really capital intensive.) [1]
Page 8
The margin on the Risk department’s salaries is also higher. [1]

Risk can charge £250 fees for every £100 of salaries. This means that the
company can actually make more profit from work done in this department
than in either of the other two. [1]
The Risk department also has a higher net profit percentage, which suggests
that overheads are not disproportionately high. [1]
If anything, Jute should consider expanding Risk to take advantage of the

higher margins and returns which can be obtained from this type of work.
It should also be noted that all three departments are being charged with
significant centralised costs that would still be borne even if the departments
ceased to operate. [1]
That strengthens the business case for retaining all of them.
[Max 5]
(ii) (a) The average time taken to convert salaries into fees is essentially the
inventory turnover ratio:
3,672/14,540 × 365 = 92 days [1]
(b) Average time taken for customers to settle bills:
1,467/23,600 × 365 = 23 days [1]

[Total 2]
(iii) The company’s quick ratio is (5,629 – 3,672)/1,357 = 1.44:1 which appears to
be reasonably healthy. [1]
It has, however, got a month's salary outstanding and relatively little cash with
which to pay it. [1]
This means that the company could find it difficult to continue trading. [1]
The main problem is that the company has two steady drains on cash: salaries
and loan interest. [1]
Income is much more erratic, being dependent on invoicing clients for work
done. [1]
[Max 4]
(iv) Invoices are settled very quickly after being presented to customers. [1]
The most important means by which the company could improve its cash
flows is by speeding up the invoicing process. [1]
This could mean scheduling work so that projects can be completed so that
invoices can be raised. [1]
Contracts with new clients should also be negotiated on the basis that work
can be invoiced at regular periods. [1]
Page 9
Given the company’s pressing need, the most reliable solution would be to
seek an injection of cash from a bank or some other source. [1]
[Max 4]
[TOTAL 20]
This question was done well by many candidates. The weakest part was
part (iii), the rest were good.
Page 10
1
3
4
5
6
7 EXAMINATION
8
9 28 September 2016 (am)
10
12 Core Technical
13
14
15
booklet.
17
18
supervisor.
19
3. You have 15 minutes of planning and reading time before the start of this examination.
20 You may make separate notes or write on the exam paper but not in your answer
21 booklet. Calculators are not to be used during the reading time. You will then have
three hours to complete the paper.
22
23
24 5. Attempt all 20 questions. Answers to questions 1–10 should be indicated on the
Multiple Choice Answer Sheet included in your booklet. From question 11 onwards
25 begin your answer to each question on a new page.
26
27
28
31 question paper.
32 In addition to this paper you should have available the 2002 edition of the Formulae
34
CT2 S2016  Institute and Faculty of Actuaries
35
1 Which of the following would be the most significant constraint on the board of a
company that wishes to issue additional equity shares?
A The company has high gearing.

B The share price is presently very high.
C The shares are presently trading at a discount to their nominal value.
D The whole of the authorised share capital has been issued.
[2]
2 Which of the following might make it cheaper to fund the use of an asset through a
finance lease rather than borrowing in order to purchase the asset outright?
A Finance leases are often offered by banks.

B Finance leases transfer the risks of ownership to the lessee.
C The lessor retains ownership of the asset.
D The term of a finance lease may be for less than the asset’s useful life.
[2]
3 Why might maximisation of profit be a less acceptable corporate objective than

maximisation of shareholder wealth?
A It is rarely to the directors’ advantage to improve profit.

B Profit can be a short-term measure of performance only.
C Profits can lead to pressure to pay dividends.
D The shareholders do not benefit from profit.
[2]
4 Which of the following is an example of an agency problem?
A It might be difficult to recruit capable directors.

B The directors might award themselves excessive salaries.
C The share price may decline because of poor sales.
D Interest rates may increase the cost of borrowing.
[2]
5 A company has 10 million shares in issue. The company’s share price is $4.00 per
share. The directors are considering a one for five rights issue at $3.50 per share.
Issue costs have been estimated at $800,000. Calculate the expected share price after
the rights issue.
A $3.85
B $3.92
C $4.62
D $4.70
[2]
CT2 S2016–2
6 A project that is under consideration has a net present value of $100m. This
evaluation takes no account of the very unlikely possibility that a natural disaster will
cause significant disruption and leave the company exposed to serious losses. It is
impossible to insure against this disaster.
Which of the following is the most appropriate response to the threat posed by the
disaster?
A Abandon the project.
B Describe the risk in an appendix to the project evaluation.
C Increase the discount rate to compensate for the additional risk.
D Subtract the expected value of the costs of the disaster from the $100m net
present value.
[2]
7 A major project has been evaluated using a probability tree, which indicates that the
project has a net present value of $25m. Which of the following describes the most
valid interpretation of this result?
A The project should definitely not proceed.

B The probability tree should be analysed further to determine the project’s risks.
C The project should definitely proceed.
D The project’s certainty equivalent is $25m.
[2]

8 The net present value of a project has been graphed as follows:
Net present
value
0
10 20
Discount rate
Which of the following statements is correct?
A The project has a single outflow of cash at the beginning, followed by a series
of inflows over its life.
B The project has a very small initial investment.
C The project has no internal rate of return.
D The project has two internal rates of return.

[2]
9 A company’s operating profit for the year was $20m, before allowing for interest.
Share capital was $11m, share premium $7m, revaluation reserve $2m, retained
earnings $6m, long term borrowings $8m and trade payables $4m.
Calculate the capital employed figure that would enable you to calculate the
company’s return on capital employed ratio.
A $27m
B $28m
C $34m
D $38m
[2]
10 Which of the following is most likely to occur when a company’s trade receivables
turnover period, in days, has reduced?
A A decrease in trade receivables and a decrease in cash.

B A decrease in trade receivables and an increase in cash.
C An increase in trade receivables and a decrease in cash.
D An increase in trade receivables and an increase in cash.
[2]
CT2 S2016–4
11 Describe why a country might enter into double taxation agreements with other
countries. [5]
12 A potential customer asserts that it is safe for a company to grant it trade credit
because the customer is a wholly-owned subsidiary of a major group of companies.
Discuss the validity of the customer’s claim. [5]
13 Describe the advantages and disadvantages of comparing the profitability of two

competing companies in terms of their earnings before interest, taxation, depreciation
and amortisation (EBITDA) rather than their profit for the year. [5]
14 An investor specialises in identifying small unquoted companies that are in need of

finance in order to grow. He invests with a view to holding these shares for the long
term, but generally sells once the companies are well established. None of the
companies in which he has invested has ever sought a stock market quotation during
his period of ownership.
Discuss the advantages and disadvantages of this approach to investment. [5]
15 Describe the role of the capital markets in disciplining company performance. [5]
16 The directors of a quoted company wish to signal their confidence in the company’s
future.
Describe how a scrip issue might be viewed as a sign of confidence. [5]
17 Jolt is a quoted company that has pursued a policy of reinvesting profits in order to
fund growth. As a result, the company has attracted a body of shareholders whose tax
positions tend to favour capital gains over dividends. Jolt’s industry faces some
difficulties that will inhibit investment opportunities for the next three or four years.
Explain:
(a) whether Jolt is likely to change its dividend policy over the period of limited
investment opportunities.
(b) how it should communicate this change. [5]
18 Derek has a substantial shareholding in a quoted company. The company issued its
latest financial statements recently. There is a significant difference between the basic
and the diluted earnings per share (EPS) figures.
Explain which EPS figure is more likely to be of interest to Derek. [5]

19 Planet is a large private company that manufactures engine parts for a multinational
car company.
Planet has a large bank loan that was taken out six months ago in order to expand the
company’s property and upgrade plant and equipment. The loan is secured against the
company’s property.
The loan agreement specifies that Planet’s board must inform the bank immediately if
Planet’s gearing ratio rises beyond 45% when calculated as debt divided by debt plus
equity. In that event, the bank is entitled to immediate repayment of the loan.
If Planet cannot afford to make the immediate repayment then the bank is entitled to
force the sale of the company’s property, followed by the company’s other assets in
the event that the funds from the property sale are insufficient.
Planet has recently had its property revalued at a significant loss. The statement of
financial position, showing the effects of the revaluation, is as follows:
Planet
Statement of financial position, present day
Before adjusting After adjusting

for revaluation for revaluation
$m $m
Non-current assets
Licences 24 24
Property 160 85
Plant and Equipment 100 100
284 209
Current assets
Inventory 80 80
Trade receivables 12 12
92 92
Total assets 376 301
Equity
Shares 90 90
Revaluation reserve 96 21
Retained earnings 12 12
198 123
Bank loan 150 150
Current liabilities
Bank overdraft 17 17
28 28
Equity and liabilities 376 301
Gearing 43% 55%
CT2 S2016–6
(i) Justify why Planet’s bank might have regarded the company as being high risk
when making the loan. [6]
(ii) Discuss the suggestion that it would make better sense for Planet’s bank to
permit the loan to continue, rather than forcing repayment through the seizure
of assets. [7]
(iii) Suggest, with reasons, the information that Planet should compile in order to
assist it in negotiating a continuation of the loan from the bank. [7]
[Total 20]

20 The information below was obtained from Trell plc’s bookkeeping records as at
31 August 2016.
(i) Prepare the following financial statements for Trell plc for the year ended
31 August 2016:
(a) statement of profit or loss [10]

(b) statement of financial position [5]
(ii) Describe the advantages and disadvantages of showing the factory at its
valuation rather than its depreciated historical cost. [5]
[Total 20]
Trell plc
£000 £000

Dividends paid 129
Factory – accumulated depreciation 1,980
Factory – cost 4,320
Investments – short term 102
Manufacturing equipment – cost 11,340
Manufacturing equipment – depreciation 2,139
Office expenses 1,440
Opening inventory – finished goods 2,304
Opening inventory – raw materials 1,332
Opening inventory – work in progress 1,476
Overdraft interest 123
Purchases of raw materials 4,608
Revenue 28,749
Salaries – administrative staff 1,512
Salaries – sales staff 1,224
Selling and advertising 1,779
Share capital 2,160
Share premium 720
Trade receivables written off 159
39,480 39,480
CT2 S2016–8
Further information:
(1) Inventory was counted at 31 August 2016 and was valued as follows:
£000
Raw materials 1,260

Work in progress 916
Finished goods 2,130
(2) Plant and machinery is to be depreciated by 20% of cost.
The factory is to be depreciated by 2% of cost.
(3) Just before the year end, Trell plc’s factory was professionally valued at £6,000,000.
The directors have decided to recognise the gain on revaluation.
(4) Corporation tax of £2,470,000 is to be provided for the year.
END OF PAPER
CT2 S2016–9
EXAMINERS’ REPORT
September 2016

Core Technical
Introduction
exclusively.
Luke Hatter
Chair of the Board of Examiners
December 2016

statements. It also considers the basis of the preparation of statements and the

calculations but candidates are not penalised for this. However, candidates may lose
marks where excessive rounding has been used or where insufficient working is shown.

examination
1. There were many excellent scripts in this examination.
2. Candidates performed well in most questions in this examination and the pass rate was
very good.
3. Question 20 was done very well which was encouraging. Candidates are very good at
preparing financial statements and also show good understanding of the main principles.
4. Question 19 was done poorly by many candidates. This type of question comes up in
most diets and is never done very well.
5. In general the MCQs were not done as well as usual although they were of the same
standard.
C. Pass Mark
The Pass Mark for this exam was 60.
Page 2
Solutions
Q1 C [2]
Q2 C [2]
Q3 B [2]
Q4 B [2]
Q5 A [2]
Q6 B [2]
Q7 B [2]
Q8 D [2]
Q9 C [2]
Q10 B [2]
Workings:
Q5 (40m + (2m × 3.5) – 800,000)/12m = $3.85* (40m + (2m × 3.5))/12m = $3.92

(40m + (2m × 3.5) – 800,000)/10m = 4.62 (40m + (2m × 3.5))/10m = $4.70
Q9 11+2+6+8 = 27
11+7+2+8 = 28
11+7+2+6+8 = 34*
11+7+2+6+8+4 = 38
The MCQs were not done quite as well as usual. Questions 1, 2 and 5 were
frequently incorrect.
Q11 Tax law often strives to ensure fair treatment of taxpayers. [1]
(both private and corporate). It would be unfair to tax the same profit twice. [1]
A double tax treaty creates the possibility of some reciprocation between countries in
preventing double taxation of overseas earnings. [1]
Tax law also strives to encourage behaviour that is in the country’s economic interest.
[1]
Double-tax treaties encourage companies to trade overseas. [1]
That creates a greater potential for exports and management of the balance of trade [1]
[Max 5]
This question was done reasonably well by many candidates although some
of the answers were brief.
Page 3
Q12 Groups of companies present consolidated financial statements that present them as a
single economic entity, [1]
but they are not legally obliged to support one another. [1]
In the event of the customer’s failure, the remainder of the group could simply permit
the subsidiary to go into liquidation. [1]
Many groups would be reluctant to permit a subsidiary to fail, in this manner because
it would generate significant bad publicity. [1]
It could easily cost the group more to deal with the damage to reputation and the
concerns expressed by other business contacts than it would to rescue the failing
subsidiary. [1]
A potential lender could easily ensure that the group would settle any unpaid balance
by demanding a written guarantee from one or more fellow group members. [1]
[Max 5]
Q13 All four of the elements that are being excluded from the figure are potentially highly
subjective. [1]
Analysts are concerned that the board of a company that wishes to overstate profits
might, for example, make very optimistic assessments of asset lives for the sake of
depreciation or amortisation. [1]
The resulting figures are, therefore, based on figures that are relatively objective and
so should be more directly comparable. [1]
The danger is that analysts may be misstating performance because these costs may
be a significant proportion of the total. [1]
There is little point in having comparable performance figures if they grossly
overstate the earnings of, say, companies in a very capital intensive industry where
depreciation is a major economic matter. [1]
[Total 5]
Q14 The investor may benefit from this arrangement because the companies may be at an
early stage of development and their founders may be prepared to accept a relatively
small amount for the shares. [1]
There could be significant capital gains from these companies. There is, however, a
significant potential for diversification so that the risks are not excessive. [1]
Unquoted companies are less regulated and are required to provide less corporate
information, so the investor may make decisions based on wrong or incomplete data
[1]
Page 4
The fact that the companies are unquoted may make it difficult for the investor to exit
when the time is right. [1]
It may be that the founders will be keen to buy back their shares at a considerable
premium in order to retain control. [1]
Failing that, it will be necessary to invest considerable time and effort in order to find
a potential buyer and then to negotiate a mutually acceptable price. [1]
[Max 5]
Many candidates gave a very brief answer to this question.
Q15 The capital markets generally gather and process information concerning expectations
of future performance. [1]
Market participants compete to identify speculative opportunities to buy or sell
mispriced securities, [1]
which creates an incentive to study all information that becomes available. [1]
The share price will fall in the event that a company’s performance is disappointing.
[1]
That provides directors with a visible indication of how they are being perceived,
which may motivate them to work harder. [1]
There is also a possibility that the declining share price will make the company a
tempting target for takeover, which could lead to the directors losing their jobs. [1]
[Max 5]
Candidates performed well in this question.
Q16 The scrip issue effectively converts retained earnings into share capital, [1]
which increases the number of shares and reduces the share price in the process. [1]
Any fall in the share price could make it impossible to issue further shares if the
market price is below the nominal price per share. [1]
Thus, creating the issue implies a belief that the share price will not decline to below
the nominal value. [1]
Scrip issues are also associated with certain other future events and so they can have
an implied significance. [1]
For example, the directors sometimes aim to maintain the dividend per share after the
increase in the number of shares due to a small scrip issue, making the shares a little
more valuable. [1]
[Max 5]
This question was done very well by candidates.
Page 5
Q17 One interpretation of the Modigliani and Miller model is that shareholders may suffer
a loss because of tax if a company changes its dividend policy. [1]
Jolt’s shareholders clearly prefer capital gains to dividends and so they will suffer a
significant tax charge if a dividend is paid without giving them the opportunity to
make arrangements. [1]
Jolt should not retain significant cash balances [1]

if there are no investment opportunities available in order to put them to work [1]
It may be better for Jolt to inform the markets that the industry is not in a suitable
condition to make additional investments and so it will be making a significant
dividend payment in due course [1]
The shareholders can then realise some or even all of their equity by selling the shares
in advance of the dividend, selling to shareholders whose circumstances lead to them
having a preference for dividend income. [1]
[Max 5]
This question was done reasonably well by many candidates. There were
also some weaker candidates who wrote very little in their answers.
Q18 The difference between the two EPS figures is a measure of the extent to which
Derek’s investment may be diluted [1]
through the exercise of warrants or other financial instruments [1]
Derek holds a significant shareholding and so his investment’s value may be
diminished in the event that these rights are exercised [1]
However, Derek will focus primarily on the company’s past performance in order to
inform him about the company’s profitability [1]
The basic EPS is a more relevant figure for determining how effective the board has
been in managing the equity invested by Derek and the other shareholders [1]
The diluted EPS is more of a “worst possible case” that might reflect how Derek’s
investment would have performed if the holders of warrants, etc. had exercised their
rights to buy shares at a fixed price [1]
[Max 5]
This question was done badly by many candidates. Few candidates

discussed EPS in any depth.
Q19 (i) The lenders will be aware that Planet’s performance is largely under the
control of a third party. [1]
Planet’s revenue could decline in the event that the car company runs into
difficulty, even if Planet itself is performing well. [1]
There is also the risk that Planet will be replaced by a cheaper or more
attractive competitor. [1]
The lender knew that its cash would be invested in particular assets, as
indicated during the loan negotiations. [1]
Page 6
These assets are unlikely to be readily convertible back to cash in the short
term and without incurring a loss. [1]
It was also clear that Planet would be highly geared, no matter what. [1]
(ii) If the bank forecloses on the loan then it would appear that it will receive a
maximum of $85m from the sale of property. [1]
The remaining assets may be difficult to sell for anything like their book
values. [1]
The licences may have little or no value in themselves. If Planet cannot trade
profitably using them then they are unlikely to find a buyer. [1]
The plant and equipment will probably be highly specialised and, again, the
market may be limited. [1]
There is a very good chance that the bank will lose a significant portion of its
$150m if it forces Planet out of business. It will stand more chance of being
repaid if it supports Planet through this difficulty. [1]
The bank may also wish to avoid the adverse publicity associated with
forcing a major employer out of business [1]
If it acquires a reputation for ruthlessness then it might deter other customers
from applying for loans. [1]
(iii) Planet’s main concern should be to draw up a plan to show how it intends to
generate future cash flows from which to keep up with the payment of
interest and the repayment of capital. [1]
A cash budget that indicates a realistic prospect of keeping up with the loan
schedule will help. [1]
Planet should list its assumptions and generate as much evidence as possible
with which to support them. [1]
For example, correspondence with the car manufacturer may demonstrate
that the potential demand for parts is healthy. [1]
The assumptions that cannot be supported in this way should be realistic and
should err on the side of caution. [1]
Planet may benefit from being able to offer the bank additional reports on its
performance in order to give the bank some reassurance that the board is
confident. [1]
Agreeing to a period of enhanced scrutiny may demonstrate that Planet’s
directors are confident in their ability to service the loan. [1]
[Total 20]
This question was done quite badly by many candidates. The average mark
was lower than for other questions. All parts were equally poor. Most
candidates did not write enough to gain high marks.
Page 7
Q20 (i) (a) Trell plc

Statement of Profit or Loss for the year ended 31 August 2016
£000
Revenue 28,749
Cost of Sales (13,312)
Gross profit 15,437
Distribution Costs (3,162)
Administrative Expenses (2,952)
Finance costs (123)
Income Tax Expense (2,470)
[10]
(b) Trell plc

Notes £000
Non-current assets
Property, plant and equipment (1) 12,933
Current Assets
Inventory (2) 4,306
Investments 102
6,496
Total assets 19,429

Equity
Called-up share capital 2,160
Share premium account 720
Total equity 14,796
Current liabilities
Tax 2,470
4,633
Total of equity and liabilities 19,429
[5]
Page 8
Notes:
(1) Property, plant and equipment
Plant and
Property machinery Total
£000 £000 £000
Cost or valuation
At 31 August 2015 4,320 11,340 15,660
Adjustment on revaluation 1,680 1,680
At 31 August 2016 6,000 11,340 17,340
Depreciation
At 31 August 2015 1,980 2,139 4,119
Charge for year 86 2,268 2,354
Adjustment on revaluation (2,066) (2,066)
At 31 August 2016 - 4,407 4,407
Net book value
At 31 August 2016 6,000 6,933 12,933
At 31 August 2015 2,340 9,201 11,541
(2) Inventories £000

Inventories comprise:
Raw materials 1,260
Work in progress 916
Finished goods 2,130
4,306
Workings:
Cost of sales
Overheads 2,664
Wages 2,880
Opening inv – raw materials 1,332
Opening inv – work in progress 1,476
Opening inv – finished goods 2,304
Purchases 4,608
Closing inv – raw materials (1,260)
Closing inv – work in progress (916)
Closing inv – finished goods (2,130)
Depreciation – equipment 2,268
Depreciation – factory 86
13,312
Distribution
Bad debts 159
Selling and advertising 1,779
Salaries 1,224
3,162
Admin
Office expenses 1,440
Salaries 1,512
2,952
Page 9
(ii) The valuation will be far more current than the historical cost, so the
shareholders will see the true value of the assets at the directors’ disposal.
[1]
That will give them a better indication of the resources at the board’s
disposal and so they will see how their investment is being managed. [1]
The valuation will be far more subjective than the depreciated historical
cost. [1]
The valuation could be open to manipulation or could be misstated through
a legitimate error. [1]
The valuation could require expensive consultancy fees, increasing the cost
of compiling the financial statements. [1]
[Total 20]
Part (i) was done extremely well by most candidates. Part (ii) was not
especially well answered with many candidates failing to write more than two
or three lines.
Page 10
1
3
4
5
6 EXAMINATION
7
8 27 April 2017 (am)
9
10
11 Core Technical
12
13 Time allowed: Three hours
14
15 INSTRUCTIONS TO THE CANDIDATE
17 booklet.
18 2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
19
20 3. You have 15 minutes of planning and reading time before the start of this examination.
You may make separate notes or write on the exam paper but not in your answer booklet.
21 Calculators are not to be used during the reading time. You will then have three hours to
22 complete the paper.
23 4. Mark allocations are shown in brackets.

24 5. Attempt all 20 questions. Answers to questions 1–10 should be indicated on the Multiple
25 Choice Answer Sheet included in your booklet. From question 11 onwards begin your
26
27

30
31 question paper.
32
34
35 CT2 A2017  Institute and Faculty of Actuaries
1 Which of the following best describes the purpose of a Chinese wall within a
securities firm?
A to preserve anonymity
B to prevent conflicts of interest
C to prevent theft
D to prevent unauthorised access
[2]
2 An option gives its holder the right to purchase 1,000 shares for £1.40 each. The
shares were trading at £1.20 when the options were issued. They are presently trading
at £1.30. The holder paid £0.10 per share for the option. What is the option’s strike
price?
A £0.10
B £1.20
C £1.30
D £1.40
[2]
3 What are the potential implications for debenture holders of an increase in interest
rates in the economy?
A Cash flows from debenture instruments will increase and the value of the
debentures will increase.
B Cash flows from debenture instruments will increase, but the value of the
debentures will remain the same.
C Cash flows from debenture instruments will remain the same, but the value of
the debentures will decrease.
D Cash flows from debenture instruments will remain the same, but the value of
the debentures will increase.
[2]
4 Why might buyers be prepared to buy zero coupon debentures?
A The company may offer exceptional security.

B The debentures may be issued at a significant discount.
C The debentures may be issued at a significant premium.
D Prevailing interest rates may be low.
[2]
CT2 A2017–2
5 What is the purpose of the margin on a futures contract?
A to ensure that the exchange’s commissions are paid
B to even out the cash flows associated with the transaction
C to link the future price to the inherent price of the underlying instrument or
commodity
D to protect the counterparties against loss

[2]
6 A company’s diluted earnings per share is significantly lower than its basic earnings
per share. How should that be interpreted?
A Heavy losses are expected.

B The company has a large number of warrants in issue.
C The company is a poor investment.
D There is an active market in traded options on the company’s shares.
[2]
7 A company has identified a loophole in accounting standards that will enable it to

overstate its reported profit, although this will be apparent from a close reading of the
notes to the financial statements.
Which of the following is the most likely result of using this loophole?
A The share price will increase but the price/earnings ratio will be unaffected.
B Neither the share price nor the price/earnings ratio will change.
C The share price will be unaffected but the price/earnings ratio will reduce.
D The share price will be unaffected but the price/earnings ratio will increase.
[2]
8 A company has a low profit margin but a high return on capital employed when
compared to its main competitors.
Which of the following interpretations is most likely to explain this combination?
A The company’s selling prices are at an optimal level.
B The company’s selling prices are at an optimal level, but the company is
spending too much on other operating activities.
C The company’s selling prices are too high.
D The company’s selling prices are too low.

[2]

9 A manufacturing company’s financial statements are based on historical cost
accounting. Which of the following best explains the problems associated with
interpreting the company’s financial statements during periods of inflation?
A The cost of inventory consumed and depreciation are both overstated.

B The cost of inventory consumed and depreciation are both understated.
C The cost of inventory consumed is understated and depreciation is overstated.
D The cost of inventory consumed is overstated and depreciation is understated.
[2]
10 A company’s operating profit is €2 million. Its finance charges were €0.5 million.
Shareholder equity is €20 million and long term borrowings are €6 million. What is
the company’s return on capital employed?
A 5.8%
B 7.7%
C 9.6%
D 10.0%
[2]
11 An engineering company has a rival, Bolt, that it is thinking of buying. Bolt’s current
market capitalisation is $800 million.
Explain whether the engineering company should pay more than $800 million in
order to acquire this company.
[5]
12 Three actuaries have decided to establish their own consultancy.
Describe the advantages and disadvantages to the actuaries of operating as a limited

liability partnership (LLP) rather than a simple partnership. [5]
13 Describe why some individual taxpayers may prefer to receive investment returns in
the form of capital growth rather than dividends. [5]
14 Stock exchange rules tend to require companies to announce “bad” news as soon as
the events are known. These announcements are sometimes called “profit warnings”.
Explain the purpose of these announcements. [5]
15 Describe why a company might buy back its own shares rather than make a
distribution in the form of a dividend. [5]
CT2 A2017–4
16 Explain why the maximum acceptable level of gearing ratio might vary from country
to country. [5]
17 Explain the relative importance of liquidity and profitability to the shareholders of a

quoted company who are analysing the company’s financial statements. [5]
18 Describe the problems faced by the external auditor in reporting on the fair
presentation of financial statements. [5]

19 Hort is an actuarial consultancy. Hort has owned a two floor office block for the past
20 years.
Improvements in technology mean that Hort has reached the point where the whole of
the upper floor is left unoccupied.
Hort’s directors are considering using the free space in the building to launch a new
consultancy venture. This would involve taking on new consultants with relevant
expertise, as well as equipping the floor with suitable IT equipment.
The initial investment in the IT equipment will be £1.5 million.
Over the next five years, Hort predicts that the fees earned from the new consultancy
venture, minus the cash outflows associated with wages and other running costs, will
have a net present value of £4.0 million.
Hort’s directors believe that they should allow something for the building in deciding
whether to proceed with this venture. Four possible arguments have been put forward
by four members of the board:
1. The building cost £2.0 million when it was acquired and it has been depreciated
by £800,000 since. That leaves a net book value of £1.2 million, of which £0.6
million could be attributed to the upper floor.
2. The cost of the building is a sunk cost and it should not be incorporated into the
project appraisal.
3. The upper floor could be sold to a third party for £2.7 million.
4. The upper floor could be rented out over the next five years, with rental income
yielding a net present value of £0.9 million.
The debate over the building has been heated because it could affect the decision to
go ahead with the project.
(i) Discuss the logic of each of the four arguments concerning the building. [8]
(ii) Explain how Hort’s Board should decide on the most appropriate treatment of
the building. [2]
Critics of the net present value (NPV) technique state that it has a fundamental flaw in
that it is possible to justify either the acceptance or rejection of almost any project by
manipulating estimates and assumptions in the evaluation of NPV.
(iii) Evaluate the assertion that this project illustrates this fundamental flaw in the
net present value criterion. [10]
[Total 20]
CT2 A2017–6
20 The information below has been extracted from Trent Ltd’s bookkeeping records.
Prepare Trent Ltd’s financial statements for the year ended 30 September 2016:
(i) statement of profit or loss [10]

(ii) statement of changes in equity [2]
(iii) statement of financial position [8]
[Total 20]
Trial balance as at 30 September 2016
£000 £000
Cash 13,780
Debenture interest 12,000
Debenture loan 135,000
Delivery staff wages 10,860
Delivery vehicle running costs 15,600
Delivery vehicles – cost 84,000
Delivery vehicles – depreciation 39,000
Plant and equipment – depreciation 145,590
Property – depreciation 43,680
Purchases 247,500
Revenue 488,400
1,148,310 1,148,310
1. Closing inventory has been counted and valued at £8,470,000.

2. Production staff wages includes £800,000 that relates to rebuilding a wall in the
company’s property. The £800,000 should be classified as part of the cost of
property.
3. Depreciation has to be calculated as follows:
• Property – 2% of cost
• Plant and equipment and delivery vehicles – 25% reducing balance
4. The tax charge for the year has been estimated at £8,450,000.
END OF PAPER
CT2 A2017–7
EXAMINERS’ REPORT
April 2017

Core Technical
Introduction
exclusively.
Luke Hatter
July 2017

statements. It also considers the basis of the preparation of statements and the


examination
1. There were many excellent scripts in this examination.
2. Candidates performed well in most questions in this examination and the pass rate was
lower than last diet but still healthy.
3. Question 20 was done very well which was encouraging. Candidates are very good at
preparing financial statements and also show good understanding of the main principles.
4. Question 19 was done poorly by many candidates. This type of question comes up in
most diets and is never done very well.
C. Pass Mark
Page 2
Solutions
Q1 B [2]
Q2 D [2]
Q3 C [2]
Q4 B [2]
Q5 D [2]
Q6 B [2]
Q7 C [2]
Q8 A [2]
Q9 B [2]
Q10 B [2]
Workings:
Q10 A (2 – 0.5) / (20 + 6) = 5.8%

B 2 / (20 + 6) = 7.7% (Correct)
C (2 + 0.5) / (20 + 6) = 9.6%
D 2 / 20 = 10%
Questions 1–10 were done very well in this diet. A number of candidates
scored full marks.
Q11 The share price should always represent an unbiased valuation for the company. [1]
The $800 million market capitalisation is likely to be a valid reflection of expected
cash flows. [1]
That expectation is, however, based on assumptions about the future operations of the
company. If it is acquired by another business then it may become more profitable.[1]
The engineering company should consider whether it truly believes that it can manage
Bolt more effectively than its current management team. [1]
There could be other reasons for paying more. For example, there could be synergies
associated with combining the two companies. [1]
It would be logical for the market to attach some value to those so that the bidder was
forced to pay something for the economies and so it will almost certainly be necessary
to pay more than the $800 million for outright ownership. [1]
[Max 5]
Many candidates achieved a pass in this question but few achieved a high
mark.
Page 3
Q12 The principal advantage is that the partners’ personal assets will not be exposed to
claims to the same extent as if the business was a traditional partnership. [1]
The LLP itself will be responsible for its own liabilities. [1]
That may prove ineffective in setting the business up if potential creditors are
concerned that the LLP may default and then they could seek personal guarantees
from the partners as individuals. [1]
It can be possible to lodge claims against individual members in the case of default by
the LLP, which would further restrict the potential for limitation of liability. [1]
The fact that there are only three members, all of whom are likely to work closely
together, means that there may be a realistic chance that it will often be possible to
hold all three liable under this provision. [1]
Potential business contacts, including clients, may regard the LLP status as implying a
lack of confidence on the part of the members. [1]
[Max 5]
This question was passed by many candidates but the marks were fairly low.
Lack of knowledge seemed to be the difficulty.
Q13 Taxpayers usually have a separate annual allowance for capital gains, which means
that an element of capital gain is effectively tax free. [1]
If they are already taxpayers then they will be taxed on dividends at their marginal
rate as a matter of course. [1]
Capital gains may be taxed at a lower rate than income, depending on the taxpayer’s
marginal rate. [1]
Capital gains offer far more scope for tax planning than income tax on dividends. [1]
The gain is not taxed until it is realised, so the taxpayer can delay the payment of tax
by continuing to hold the shares. [1]
In the same way, the taxpayer could deliberately realise a gain in order to make full
use of any spare capacity in the annual allowance for capital gains. [1]
No such discretion can be applied to income from dividends. [1]
[Max 5]
Many candidates passed this question but did not get a high mark. The
candidates knowledge of capital gains tax was limited.
Q14 The stock exchange is keen to ensure that markets are orderly and that any volatility is
minimised. [1]
If companies withhold bad news until the last possible minute then markets may
overreact when the news is eventually released. [1]
An earlier announcement will avoid the reaction associated with unrealistic
expectations being allowed to develop, followed by a sudden disappointment. [1]
Page 4
Making early announcements reassures the markets that bad news falling under these
rules must be announced, thereby reducing the threat that speculation will undermine
confidence. [1]
The knowledge that any serious adverse news must be reported should maintain
confidence in market prices. [1]
Profit warnings reduce the risk of manipulation and profiteering by directors. For
example, it would be tempting to sell shares in advance of the publication of bad
news. [1]
Profit warnings reduce or even close the window that might be abused for this
purpose. [1]
[Max 5]
This question was not answered very well. Candidates wrote about share
prices but did not really answer the question. There seemed to be a lack of
knowledge on announcements.
Q15 A repurchase may send out a more acceptable message to stakeholders if the entity
has a large surplus to distribute. [1]
An equivalent dividend may be unacceptable to, say, employees or customers because
it may appear that the company is lavishing profit on its shareholders that could
otherwise have been used to increase wages or reduce selling prices. [1]
A repurchase will create the impression that the shareholders are sacrificing some of
their equity in the process. [1]
A repurchase will also avoid any expectation that future dividends will continue at
this level or will increase even further. [1]
A repurchase may be motivated by a desire to rid the company of a large cash

balance, rather than be the result of a significant equity balance arising from
successful operations. [1]
The directors may be concerned that a dividend will be viewed as an admission of
their inability to put the funds to good use in expanding the business. [1]
It may be more tax efficient for some shareholders to receive the proceeds of the
distribution as a share repurchase rather than a dividend. [1]
[Max 5]
This question was not done very well. It seemed to be a lack of knowledge
that caused the problem. Many candidates did not answer the question but
just wrote about repurchase of shares in very general terms.
Page 5
Q16 Tolerance for gearing depends in part on the attitude of lenders, [1]
which can vary between countries. Some countries have a strong emphasis on equity
financing, with very little direct engagement between companies and their lenders. [1]
In such cases, the banks are less likely to support a company through any short to
medium term difficulties. [1]
That would discourage borrowers from being highly geared and lenders from
advancing a large amount. [1]
There are also cultural issues, with stakeholders having different attitudes towards
risk. [1]
In some countries the additional risks associated with gearing are tolerated because it
offers a cheaper source of finance. [1]
In such countries it may be deemed less acceptable to foreclose in response to a short-
term difficulty and so the downside risks are more easily managed. [1]
[Max 5]
This question was not done very well, in many cases candidates could
discuss gearing well but did not answer the question. It seemed to be a
problem with applying knowledge to the question.
Q17 Shareholder wealth increases because of profit, so the shareholders will have little
interest in investing in a company that is not expected to be profitable. [1]
Liquidity is simply an enabling factor that ensures the company’s survival in the short
term. [1]
If a company is consistently profitable then it should be capable of generating cash

from operations. [1]
The link between profit and cash can be indirect, but in the long term a profitable
company should be capable of generating cash and so should be able to survive a
liquidity crisis, even if that requires further borrowing. [1]
Companies report annual profit figures, which give shareholders a meaningful insight
into profitability. [1]
The statement of financial position is a snapshot at a point in time, so shareholders see
very little about liquidity because even the latest statement of financial position will
be several weeks out of date with respect to liquidity. [1]
[Max 5]
Page 6
Q18 The basic problem faced by the external auditor is that truth and fairness is difficult to
define and so there may be doubt as to whether any given set of financial statements
possess that quality. [1]
The auditor’s credibility could be undermined by subsequent complaints about the
truth and fairness of a set of financial statements on which a clean audit report has
been published. [1]
The preparation of financial statements is governed by IFRS, but those standards are
open to interpretation and application in different ways. [1]
The auditor’s problems are exacerbated by the fact that there may be agency issues
which encourage the directors to abuse any subjectivity in the preparation of the
financial statements. [1]
The directors may be keen to find and exploit loopholes in IFRS and argue that the
financial statements comply with the rules, so therefore they are “true and fair”. [1]
The external auditor is constantly working against a whole industry devoted to
“financial engineering” that develops such creative accounting schemes for sale to
companies in order to enhance the impression created by their financial statements. [1]
[Max 5]
This question was not done particularly well. The main issue seems to be a
lack of knowledge.
Q19 (i) The accounting net book value has no direct relevance to the future cash flows
associated with this venture and so it should effectively be disregarded. [1]
The only issue is that the financial statements will reflect this value to some
extent in reporting on future performance and so we may have to consider how
it will impact on reported earnings. [1]
It is true that the past cost of the building is a sunk cost, but that is a
misleading argument. The upper floor has a value and that value changes
according to the manner in which it is used. [1]
Even if the directors choose to leave the floor unoccupied and generating no
return, there is an economic decision being made to forego future revenues. [1]
Occupying and using the upper floor for the consultancy venture will mean
that the directors have to forego the £2.7m that could have been obtained from
this sale. [1]
This is an opportunity cost that will undoubtedly affect future cash flows. [1]
The rental income is also an opportunity cost. It should be weighed up against

the potential sale of the floor. [1]
While the sale generates more than £900,000, the rental agreement leaves us in
possession of the property and so we should allow for that potential cash flow
in comparing rental to sale. [1]
Page 7
(ii) It should focus on future cash flows when choosing between these figures. [1]
Overall, it should estimate the opportunity cost associated with using this floor
by determining the higher of the overall expected value to be obtained from
renting out the upper floor and selling it. [1]
It may have to envisage a number of scenarios for the end of the five year
rental period so that it can estimate ongoing cash flows. [1]
[Max 2]
(iii) Hort’s directors had to make highly subjective judgements concerning the
project’s future cash flows and also the required rate of return at which these
would be discounted. These judgements are open to manipulation in order to
show a positive NPV. [1]
For example, the opportunity cost associated with the potential rental could be
reduced or even eliminated if the directors chose to act on the assumption that
it would be difficult to find a tenant for the whole period. [1]
There is a limit to the extent to which Hort’s directors could manipulate this
evaluation. They will be held accountable for the outcome of their investment
decisions. [1]
Overstating the expected return on this project is likely to lead to the board
being asked to comment on the reasons for a failed project in the fullness of
time when the costs are written off Hort’s financial statements and show a
poor return on capital employed. [1]
If the board consistently rejects profitable projects then Hort will report poor
returns through under investment. [1]
All investment appraisal techniques involve considerable subjectivity, so NPV

is probably no worse than any other in that respect. [1]
For example, even payback could be manipulated through the distortion of
cash flows or the threshold for an acceptable payback period stretched or
compressed to fit the board’s wishes. [1]
Projects are usually evaluated in a formal way through a project appraisal

document. That will create a paper trail back to the reasoning applied by
Hort’s directors in deciding to proceed with this project. [1]
Even if that document will never be released to the shareholders, its existence
will deter overt manipulation because it could be used as the basis for action
against the directors who approved the investment. [1]
Net present value does offer the potential to align investment appraisal
decisions with the shareholders’ welfare. The fact that it may be open to abuse
does not undermine the internal economic efficiency of the technique. [1]
Page 8
The technique provides a framework for pulling together expectations about

the project and so it enables decision makers to evaluate the expected outcome
in a logical manner. [1]
[Max 10]
[Total 20]
This question was done very badly by most candidates. The marks in all
three sections were very poor.
This type of question is always in the exam it is therefore surprising that

candidates do so badly in this question. Basically it is a lack of knowledge
that is the problem.
Q20
Trent Ltd
Statement of Profit or Loss for the year ended 30 September 2016
£000
Revenue 488,400 [½]

Gross profit 151,724
Finance charge (12,000) [½]
Tax expense (8,450) [½]
Format [1]
Trent Ltd
Statement of Changes in Equity for the year ended 30 September 2016
Equity Retained Total

shares earnings
£000 £000 £000
Opening balance 225,000 63,540 288,540 [½]

Profit for the year 37,414 37,414 [½]
Dividend (45,000) (45,000) [½]
Closing balance 225,000 55,954 280,954
Format [½]
Page 9
Trent Ltd
Statement of Financial Position as at 30 September 2016
£000
Non-current assets 373,204 [½]
Current assets
Inventory 8,470 [½]
Trade receivables 37,050 [½]
Cash 13,780 [½]
59,300
Equity
Share capital 225,000 [½]
Retained earnings 55,954 [½]
280,954
Debentures 135,000 [½]
Current liabilities
Trade payables 8,100 [½]
Tax 8,450 [½]
16,550
432,504
Format [1]
[10]
Note:
Non-current assets
Property Plant and Delivery Total
equipment Vehicles
£000 £000 £000 £000
Cost 294,800 271,230 84,000 650,030 [1]
Depreciation
Opening balance 43,680 145,590 39,000 228,270 [½]
Charge for year 5,896 31,410 11,250 48,556 [½]
Closing balance 49,576 177,000 50,250 276,826
Net book value 245,224 94,230 33,750 373,204 [½]
Page 10
Workings:
Cost of sales
Manufacturing overheads 20,610 [½]
Opening inventory 7,920 [½]
Production staff wages 32,610 [½]
Less: reclassified as capital (800) [½]
Purchases 247,500 [½]
Closing inventory (8,470) [½]
Property depreciation 5,896 [1]
Plant and equipment depreciation 31,410 [½]
336,676
Property depreciation = (294,000 + 800)  2% = 5,896

Delivery staff wages 10,860 [½]
Delivery vehicle running costs 15,600 [½]
Sales staff salaries 35,550 [½]
Delivery vehicle depreciation 11,250 [½]
73,260
Administrative expenses 8,000 [½]
Directors' salaries 12,600 [½]
20,600 [1]
[Total 20]
This question was done extremely well with many candidates scoring full
marks.
Page
11
EXAMINATION
4 October 2017 (am)

Core Technical
1. Enter all the candidate and examination details as requested on the front of your
answer booklet.
supervisor.
You may make separate notes or write on the exam paper but not in your answer
booklet. Calculators are not to be used during the reading time. You will then have
5. Attempt all 20 questions. Answers to questions 1–10 should be indicated on the

begin your answer to each question on a new page.
question paper.

1 A company often evaluates projects by means of the receipts/costs ratio:
Net present value (NPV) of the gross revenues

——————————————————————–
Net present value (NPV) of the capital and running costs
Which of the following best explains the usefulness of this ratio?
A It is easy to identify positive and negative net present value (NPV) projects on
the basis of this ratio.
B The capital and running costs have been committed and a ratio that is just over
1.00 may indicate that the potential benefits do not justify the risks.
C The ratio helps with the evaluation of projects that can be abandoned before
completion.
D The ratio is easier to calculate than internal rate of return (IRR).

[2]
2 Which of the following best explains what would happen if a quoted company’s
directors accept a positive net present value (NPV) project that has a very high
opportunity cost?
A The opportunity cost will only be a problem if the shareholders are informed
of it.
B Shareholder wealth cannot be affected by opportunity costs.
C The shareholders will discover the opportunity cost with the passage of time.
D
The shareholders will not care about the opportunity cost provided positive
NPV projects are being accepted.
[2]
3 It has been suggested that the long term returns from investing in equities are higher
than those for many other types of investment. What does this tell us about the cost of
equity to the issuing companies?
A Equities are a relatively expensive source of finance.
B Equities are a relatively inexpensive source of finance.
C It tells us very little because there is no link between the cost of equity and the
returns offered to shareholders.
D The cost of equity finance is excessive.

[2]
CT2 S2017–2
4 A company has bonds in issue, repayable in seven years, with a nominal value
of $100m and a coupon rate of 8% p.a. The company’s credit rating has been
downgraded. Which of the following statements best reflects the implications of the
revised credit rating for the company’s cost of debt?
A The cash flows will be unaffected, so the cost of debt will remain the same.
B The market value of the bonds will decline and the cost of debt will increase.
C The market value of the bonds will increase and the cost of debt will decline.
D The credit rating will affect future issues only.

[2]
5 A new International Financial Reporting Standard (IFRS) has come into effect,
requiring companies to change an important accounting policy.
Which of the following best explains the implications of the concept of consistency in
this case?
A Consistency requires that the new IFRS be ignored in order to give a true and
fair view.
B The audit report should carry an emphasis of matter paragraph to highlight the
change in the accounting policy.
C The financial statements should show two versions of the figures, both with
and without the changes arising from the new IFRS.
D
The International Accounting Standards Board is responsible for addressing
the issues relating to consistency.
[2]
6 A typical cash flow statement adds depreciation back to operating profit in order to
arrive at cash generated from operations.
Which of the following explains the treatment of depreciation?
A Depreciation affects cash flow but not profit.
B Depreciation affects profit but not cash flow.
C Depreciation is a subjective estimate.
D Depreciation is not an operating expense.

[2]

7 Which of the following best explains the implications of the going concern concept in
financial accounting?
A It is a fact that businesses tend to continue indefinitely.
B Incorrect valuations of property, plant and equipment can be tolerated.
C The figures will remain the same if the business faces closure.
D The financial statements will be comparable from period to period.

[2]
8 Who is responsible for the truth and fairness of a company’s financial statements?
B the chief accountant
C the external auditors
D the International Accounting Standards Board (IASB)

[2]
9 A project that is under consideration has a net present value of $100m. This
evaluation takes no account of the very unlikely possibility that a natural disaster will
cause significant disruption and leave the company exposed to serious losses. It is
impossible to insure against this disaster.
Which of the following is the most appropriate response to the threat posed by the
disaster?
A Abandon the project.
B Attach a description of the risk to the project evaluation.
C Increase the discount rate to compensate for the additional risk.
D
Subtract the expected value of the costs of the disaster from the $100m net
present value.
[2]
CT2 S2017–4
10 Which of the following best describes the circumstances in which an emphasis of
matter paragraph will be included in the external auditor’s report?
A The auditor wishes to draw attention to a specific statement elsewhere in the

audit report.
B The financial statements contain a material uncertainty.
C The financial statements do not give a true and fair view.
D There is an immaterial irregularity in the financial statements.

[2]
11 Describe why many countries give individuals a personal allowance which effectively
means that income up to that amount is not taxed. [5]
12 Describe the relevance of the non-controlling interest in a set of consolidated financial

statements to the shareholders of the parent company. [5]
13 An actuarial consultancy has purchased a new computer system.
Explain the difficulties associated with determining the useful life of that asset for
depreciation purposes. [5]
14 Describe why it is necessary for the International Accounting Standards Board (IASB)
to identify the users of financial statements. [5]
15 Some major accountancy firms have converted themselves from traditional

partnerships to limited liability partnerships (LLP).
Explain the potential advantages of doing so. [5]
16 Test the proposition that agency problems can be eliminated by paying company
directors with a mixture of shares and salary. [5]
17 Describe why swaps are mutually beneficial to both parties. [5]

18 A quoted company’s share price has remained constant for almost a year and the
shareholders are becoming impatient because they wish to see the price rise. One
of the company’s directors has suggested that the company should consider making
a one for ten scrip issue, citing evidence that the capital markets often infer that the
dividend per share will remain the same after such an arrangement and so the total
dividend to be paid will increase, thereby increasing the share price.
Explain the logic of the director’s suggestion. [5]
CT2 S2017–6
19 The following figures have been extracted from the financial statements of Fratton, a
manufacturing company.
Extracts from income statement for the year ended 31 August
2015 2016 2017

$000 $000 $000
Revenue 800 900 1,000

Purchases 480 513 520
Cost of sales 476 506 515
Extracts from statement of financial position for the year ended 31 August
2015 2016 2017

$000 $000 $000
Current assets
Inventory 40 47 52
Trade receivables 67 86 105
Cash at Bank 16 8 2
————–———————
123 141 159
————–———————
Current liabilities
Trade payables 72 90 104
Tax 14 20 28
————–———————
86 110 132
————–———————
The following liquidity ratios have been calculated for the first two sets of figures:
2015 2016
Current ratio 1.4 :1 1.3 :1

Quick ratio 1.0 :1 0.9 :1
Inventory turnover 31 days 34 days
Trade receivables turnover 31 days 35 days
Trade payables turnover 55 days 64 days
(i) Calculate the liquidity ratios for 2017. [5]
(ii) Explain why it may be important to consider trends in liquidity ratios rather
than the figures as at a single point in time. [4]
(iii) Discuss Fratton’s liquidity. [6]
(iv) Explain Fratton’s treatment of its trade payables. [5]

[Total 20]

20 Bowmax is a growing company in the hotel industry that has recently been listed on
the stock market. When the company was privately owned, the directors could meet
informally with the shareholders in order to establish their personal preferences for
the company’s financial strategy. Now there are many more shareholders and the
shares trade freely on the open market.
The company’s latest statement of financial position has been summarised as follows:
Bowmax
Summarised statement of financial position as at 31 August 2017
$m
Property at valuation 180

Plant and equipment at cost less depreciation 17
Current assets 14
—–
211
—–
–—
Share capital 20
—–
211
—–
–—
The profit for the year was $32m.
Bowmax’s directors are debating the advantages and disadvantages of paying a

significant large dividend, perhaps $25m. Other quoted companies in the industry
tend to pay out a substantial proportion of their earnings.
A dividend of that size would require Bowmax to borrow cash. The board is
considering issuing $30m of debentures.
(i) Discuss the relevance of similar companies’ dividend policies in informing

Bowmax’s directors. [12]
(ii) Discuss the advantages to Bowmax of making the proposed debenture issue.
[8]
[Total 20]
END OF PAPER
CT2 S2017–8
EXAMINERS’ REPORT
September 2017

Core Technical
Introduction
Luke Hatter
December 2017

understanding of corporate finance including knowledge of the instruments used
by companies to raise finance and manage financial risk and to provide the ability
to interpret the accounts and financial statements of companies and financial
institutions.
2. This paper examines basic finance including raising funds by a variety of

methods, taxation, net present value and project appraisal and other topics; it has
both calculations and essay type questions on these topics. The paper also
examines financial reporting including preparation of the main financial
statements and interpretation of financial statements. It also considers the basis of
the preparation of statements and the information needs of a variety of end users
of financial statements.

depending on whether figures obtained from tables or from calculators are used in
the calculations but candidates are not penalised for this. However, candidates
may lose marks where excessive rounding has been used or where insufficient
working is shown.
B. General comments on student performance in this diet of the examination
As usual candidates found the large finance question challenging. The marks were
low for question 20. The marks were also lower than usual for the MCQ
questions. Very few candidates scored full marks for the MCQs and a number of
candidates scored low marks which was unusual.
C. Pass Mark
Page 2
Solutions
Q1 B [2]
Q2 A [2]
Q3 A [2]
Q4 B [2]
Q5 D [2]
Q6 B [2]
Q7 B [2]
Q8 A [2]
Q9 B [2]
Q10 A [2]
These questions were not done particularly well. Some candidates did
achieve full marks but many scored less than 10marks.
Q11 A personal allowance may be a fairer basis for taxing a population that has a wide range
of incomes. [1]
Individuals who have low incomes may pay little or nothing in tax because up to 100%
of their earnings might be taken out of the tax system. [1]
The effective rate of tax for an individual who earns a little more than the personal
allowance threshold will be far smaller than the basic rate of tax, while a high income
individual will obtain relatively little benefit in terms of marginal rates. [1]
It is frequently argued that progressive tax systems are fairer and more just because they
take a larger proportion of income from those who can afford it the most. [1]
Personal allowances can simplify the collection of tax. [1]
Individuals on a low income may not have to pay any tax, thereby reliving the tax
authorities from the administrative burden of taxing them and collecting the tax. [1]
[Max 5]
This question was done reasonably well by most candidates. Most

candidates clearly understood personal allowances and their effect.
Q12 The parent’s shareholders have invested in an economic entity that controls 100% of the
group members’ assets. [1]
The NCI is essentially a source of equity finance that funds some of the assets owned
by subsidiary companies. [1]
The parent shareholders will have to share the profits created by any partly-owned
subsidiaries with the NCI, which may prove expensive. [1]
Page 3
The NCI may also have certain rights in the event that the subsidiary is being managed
in a manner that puts the group’s interests before those of the subsidiary shareholders.
[1]
The entry in the consolidated financial statements may serve as a warning to the parent
shareholders that their control of the subsidiaries should not be abused. [1]
Ultimately, the NCI is a source of finance for which the parent shareholders should
make the group’s senior management accountable. [1]
Profitability should reflect the finance invested by the NCI. [1]
[Max 5]
This question was done poorly by many candidates. It appeared that

candidates had limited knowledge of non-controlling interest.
Q13 Any assets’ expected life is an estimate that will almost certainly run for years into the
future. [1]
It is almost inevitable that any such estimate will prove to be incorrect when the asset is
eventually disposed of. [1]
Those errors will be apparent to the shareholders and the company may be queried as to
why depreciation has been under or overstated. [1]
There is a particular problem with this type of asset because some asset lives are
determined by wear and tear while others are a matter of technological obsolescence.
[1]
A computer network may have a very long potential physical life, but will almost
certainly face replacement when a more cost-effective technology is introduced. [1]
So the factors that affect this estimate are almost wholly outside of the consultancy’s
control. [1]
[Max 5]
This question was done well with most candidates demonstrating

knowledge of depreciation and assets.
Q14 The whole point of preparing financial statements is to inform decisions. [1]
There would be no point to accountants or accounting if the statements that are
produced are not used. [1]
Meeting user needs implies knowing who the users are, so that their interests can be
determined and addressed. [1]
Different user groups have different needs. [1]
Page 4
For example, equity investors need to understand whether management decisions are
enhancing their wealth and so the focus is on profits and gains. [1]
Lenders are more interested in the security of their advances and so they are more
interested in having prudent valuations of assets. [1]
The IASB claims that its financial statements are generally useful to all designated user
groups, arguing that financial statements developed for equity investors will meet the
needs of all other interested parties. [1]
[Max 5]
Many candidates scored a bare pass for this question. Candidates

could have discussed the uses of financial statements more clearly.
Q15 The individual partners in a traditional partnership are jointly and severally liable for
the firm’s obligations. [1]
That means that their personal exposure to personal liability could be potentially
unlimited in the event that a claim is lodged for, say, a negligent audit report published
by the firm. [1]
In the first instance, the claim would be against the firm’s assets, but the personal assets
of the individual partners would then be at stake if the firm’s assets proved insufficient.
[1]
Joint and several liability may mean that a partner could be at risk of loss for a decision
taken by another partner who has acted negligently. [1]
With an LLP the members’ personal wealth would not be at stake to the same extent,
although individual members who had behaved negligently could be at risk of direct
claims being lodged against them. [1]
A significant claim that damaged the LLP as a whole would have a negative impact on
the members. [1]
The equity tied up in a successful firm could be the members’ most significant assets
and so the collapse of the LLP could still be catastrophic even if the downside is not as
bad. [1]
[Max 5]
This question was done poorly by many candidates. Many candidates

wrote about limited liability companies instead of partnerships and
scored a low mark.
Q16 Agency problems arise because the interests of the shareholders and the directors
diverge. [1]
If the directors are paid a salary then they have no particular incentive to seek to
maximise shareholder wealth. [1]
Page 5
They could become risk averse because there is no point in pursuing risky projects that
could cost them their jobs in the event of failure, with the benefits going to the
shareholders in the event of success. [1]
Replacing some of the salary that would otherwise be paid to the directors will give
them a stake in the company and could encourage them to work harder towards a
higher share price. [1]
This will be a partial solution, at best, because the board is unlikely to enjoy much
more than a small percentage of any increase in market capitalisation. [1]
Thus, the effect of the incentive may be limited. [1]
The other problem is that the board cannot diversify to the same extent as the
shareholders. [1]
The problem of risk aversion may not be addressed to any great extent by linking even
more of the directors’ financial wellbeing to that of the company. [1]
[Max 5]
This question was done very well by many candidates and probably
had the highest number of candidates getting full marks of any of the
short questions.
Page 6
Q17 The whole point of a swap is that two parties arrange to exchange future cash flows
[1]
In general, the basis for most exchanges is that they provide the parties involved with
some benefit; otherwise they would be unlikely to occur. [1]
One reason for a swap may be that two parties have matching commitments that do
not suit their circumstances, such as a fixed interest borrower who would prefer
floating rate debt and a floating rate borrower who wishes fixed. [1]
A swap would have the effect of permitting the two parties to take over each other’s
cash flows, effectively converting the fixed rate to floating and vice versa. [1]
This arrangement will be far cheaper and far more profitable than repaying the debt
early and taking out a replacement. [1]
Swaps can also assist borrowers to capitalise on any specific advantage in the
markets. [1]
For example, banks can borrow at variable rates that are lower than for most potential
borrowers. [1]
A swap arrangement would make it possible for a bank to raise variable rate debt,
swap with a counterparty who has fixed rate borrowings, sharing the specific
advantage that the bank has in the capital markets. [1]
[Max 5]
This question was done well by many candidates with many candidates
defining swaps and giving good examples. Candidates were awarded
marks for good examples.
Q18 The logic behind the suggestion depends on the likelihood of the market making that
inference. [1]
If the markets believe that the board is communicating an intention to maintain the
dividend per share then the scrip issue will be viewed as a sign of confidence and the
share price could increase. [1]
The capital markets take account of the directors’ credibility when interpreting any
signals. If the directors have a good reputation then they will risk that if they
deliberately send out a misleading signal and so the markets will have greater
confidence. [1]
The markets will value the prospect of an increased in the context of the company’s
ability to maintain that payment. [1]
If the dividend is increased beyond the company’s ability to maintain that growth then
the board would be eating into capital and the share price could even decrease. [1]
The share price is more a reflection of the company’s ability to generate net cash than
its ability to pay dividends in the short term. [1]
[Max 5]
Page 7
This question was done well with a number of candidates achieving full
marks. Some candidates discussed rights issues instead and did not
understand the difference. That was the most common error.
Q19 (i)
Current ratio 159/132 1.2:1 [1]
Quick ratio (159 – 52)/132 0.8:1 [1]
Inventory turnover 52/515*365 37 days [1]
Trade receivables turnover 105/1,000*365 38 days [1]
Trade payables turnover 104/520*365 73 days [1]
(ii) Liquidity is essentially a secondary matter for most businesses. [1]
If liquidity becomes a problem then the company could fail due to an inability
to pay its debts. [1]
If liquidity is adequate then there is no great advantage in having any more

tied up in working capital. [1]
The closing position with regard to liquidity can prove misleading when
viewed in isolation. [1]
For example, a supermarket may have a very low current ratio, but an analysis
of past trends may reveal that it has had a low but stable ratio for many years.
[1]
In that case, the poor ratio is clearly adequate. [1]
Trends can also reveal the effectiveness of strategies for managing liquidity.
[1]
For example, a company with excessive cash balances should be aiming for
decreases in liquidity in order to put those resources to good use. [1]
[Max 4]
(iii) Fratton’s liquidity is a matter of some concern. The ratios are low, but they are
declining. [1]
The decreasing current and quick ratios may suggest that the company is
running into increasing difficulties and that it may not be able to sustain a
quick ratio of less than 1.0. [1]
The components of working capital also suggest that the company may be
running into difficulty. [1]
Page 8
The increasing number of days in inventory and receivables turnover would

suggest that more and more cash is being tied up in these assets, despite the
fact that they do not yield any return. [1]
The key issue is that Fratton is steadily running out of cash. [1]
The declining cash balance will soon cross over to an overdraft situation. [1]
If that is not addressed in time then the company may be unable to meet its
commitments to staff and suppliers and be forced out of business. [1]
[Max 6]
(iv) Trade payables are suppliers who provide trade credit. That credit is a source
of short-term finance. It is not free of charge, but the cost is a fixed element of
the invoiced cost price. [1]
It follows that the cost of trade credit can be reduced by delaying payments
because the implicit interest will not be adjusted for any slight delay. [1]
It would appear from both the increase in the absolute amount and the increase
in the turnover that Fratton is using its trade credit to make good any shortfall
in cash for trading purposes. [1]
Some of the cash that is being tied up in inventory and receivables is being
taken from the suppliers by delaying payment. [1]
The danger is that Fratton will take excessive advantage of its suppliers. [1]
Up to a point, suppliers wish to make sales and so they cannot afford to

alienate customers, so a certain level of excessive credit will be tolerated. [1]
If that goes too far then the suppliers may decide to withdraw trade credit
because they are afraid of being left with unpaid debts. [1]
They may also blacklist Fratton as a slow payer with the agencies that compile
registers of slow and delinquent payers, threatening Fratton’s ability to
generate trade credit at all. [1]
[Max 5]
(i) Many candidates scored 5 marks which was excellent. In

general this part of the question was done very well.
(ii) This section was done quite well. Most candidates understood
liquidity.
(iii)Again this section was done reasonably well by many

candidates. Some candidates did not mention the overdraft at
Page 9
all.
(iv) This question was done quite well. Some candidates did not
expand their answer sufficiently to gain a high mark.
Q20 (i) Modigliani and Miller developed a hypothesis that dividend policy had no
effect on shareholder wealth. [1]
Their model relied on a host of assumptions, including the absence of tax. [1]
Shareholder tax preferences are a key factor in deciding whether to pay a

dividend. [1]
In theory, withholding and reinvesting profit will yield a capital gain that may
suit shareholders whose income is taxed heavily, but who face a lower
effective rate on capital allowances. [1]
In Bowmax’s case, it may be that the capital markets will use industry norms
to infer the company’s dividend policy. [1]
If the MM clientele effect does, in fact, occur then shareholders with a

preference for dividend income will be disappointed if the company withholds
a dividend in order to secure a capital growth. [1]
That may lead to a spurt of selling that may not be offset by a corresponding demand
from shareholders with a desire for capital gains. [1]
The directors should review analyst reports and other information sources about the
hotel industry to determine the market expectations concerning dividend practices in
the industry. [1]
The other thing that the directors should consider is that they are newcomers to the
stock exchange. [1]
The market may be reluctant to invest in a new entrant without some encouragement.
[1]
Paying a sizeable dividend, in line with industry norms, will indicate some confidence
on the part of the directors. [1]
The directors will be risking their careers if they pay an excessive amount that the
company cannot afford and so the market would view this as a favourable signal. [1]
Regardless of these arguments, it is perfectly acceptable for the directors to determine
their own view as to what level of dividend the company should pay. [1]
If they feel that a lower dividend would be appropriate then it might be sensible to
brief analysts and make an announcement to that effect. [1]
The markets will be far less prone to disappointment if the board makes its plans clear
from the outset. [1]
[Max 12]
Page 10
(ii) The debenture issue has the effect of replacing equity with debt. [1]
In theory, that would have the effect of reducing Bowmax’s WACC because the
interest will be lower than the cost of equity and it will be tax deductible. [1]
Debt of $30m will leave the company with a very low gearing ratio. [1]
The company has no long term borrowings at the moment and so a small debenture
issue may actually improve the capital structure. [1]
Judicious use of borrowings is a sensible way to demonstrate confidence on the part
of the directors because they are signalling that they are willing to commit future cash
flows to the payment of interest and principal. [1]
Conversely, an insistence on being wholly financed by equity may imply some
concerns. [1]
The fact that Bowmax is in the hotel industry makes borrowing even more sensible.
[1]
The company has significant property holdings that are showing a gain on valuation
[1]
The lenders can secure their advances against that property and so the overall cost of
borrowing should be lower. [1]
This would essentially give Bowmax an opportunity to realise some of the capital
gain and return its to the shareholders through the proposed dividend. [1]
[Max 8]
(i) Many candidates did this question quite well and passed it.
There were few high marks.
(ii) This question was not done very well and many candidates
scored a bare pass. Candidates did not really discuss
WACC very well and did not make a case for hotels
borrowing money.
Page
11
EXAMINATION
16 April 2018 (pm)

Core Technical
answer booklet.
supervisor.

question paper.

1 Which of the following best explains why the maximisation of shareholder wealth is
said to be the primary objective for company directors?
A It aligns the directors’ interests with those of the shareholders.
B It eliminates agency problems.
C It maximises profit.
D It provides a measurable basis for evaluating decisions.

[2]
2 One of a firm’s major customers buys large quantities of goods on trade credit. The
customer’s payments have started to become erratic and are often slightly overdue.
Which of the following would be the most appropriate response of the firm to this
behaviour?
A Cease all future credit sales.
B Initiate court action against the customer for immediate payment of all overdue
balances.
C Limit future credit sales while overdue balances are outstanding.
D Seize all unpaid goods from the customer’s premises.

[2]
3 Which of the following would indicate that Albion is an associated company of

Bromwich?
A Bromwich can appoint two of Albion’s seven board members.
B Bromwich can appoint four of Albion’s seven board members.
C Bromwich can insist on having a non-voting observer attend Albion’s board

meetings.
D Bromwich can replace any of Albion’s board members as and when it wishes.
[2]
CT2 A2018–2
4 Which of the following is NOT a correct interpretation of the prudence concept?
A An asset that cost $400,000 was professionally revalued at $500,000 and that
valuation has been recognised in the financial statements.
B An asset that could be sold for between $500,000 and $800,000 has been
valued at $400,000 in the financial statements.
C An asset that could be sold for between $500,000 and $800,000 has been
valued at $600,000 in the financial statements.
D
An intangible asset could be worth up to $800,000, but the asset’s value has
not been recognised in the financial statements.
[2]
5 An investor cannot afford to construct a properly diversified portfolio. Which of the

following best describes the significance of the beta of potential investments to that
investor?
A Betas have no use whatsoever to this investor.
B Low beta investments will be a safer investment for this investor.
C The investor should focus on high beta stocks if she believes that the stock
market will rise.
D
The beta co-efficient remains just as relevant even when the investor cannot
hold a diversified portfolio.
[2]
6 A project has been evaluated at its required rate of return of 12% p.a. and has been
found to have a net present value of zero. How should this finding be interpreted?
A The project delivers an internal rate of return of 12% and so it should be

accepted.
B The project should be re-evaluated at a lower rate in order to justify its

acceptance.
C The project will reduce shareholder wealth and so it should be rejected.
D There is no point in investing in this project and so it should be rejected.

[2]

7 Which of the following best reflects the significance of a company receiving an
unmodified audit opinion?
A The company is a good investment.
B The company’s financial statements are accurate.
C The company’s financial statements can be relied upon for stewardship

purposes.
D The directors have not abused their position of trust.

[2]
8 Which of the following is the most realistic interpretation of a company having a low
asset utilisation ratio and a high profit margin?
A The company is trading at a loss.
B The company’s selling prices are high, possibly restricting sales activity.
C The company’s selling prices are low, possibly encouraging sales activity.
D The company’s selling prices are optimal.

[2]
9 Which of the following best explains why intangible assets are excluded from the
calculation of asset cover?
A Intangible assets are generally worthless.
B Intangible assets are not owned by the company.
C Intangible assets cannot be transferred to the lender in the event of default.
D
Intangible assets may be difficult to realise in the event of the company’s
failure.
[2]
CT2 A2018–4
10 An investment project has been evaluated using Monte Carlo simulation. After
running the simulation 2.5 million times, the results have stabilised and the expected
net present value is positive and averages $1 million, with a range of outcomes
varying from minus $200,000 to plus $1.8 million. Which of the following statements
best interprets these results?
A The project satisfies the net present value criterion.
B The project should definitely proceed.
C This is a low risk project.
D The model should be run another 2.5 million times in order to be certain.
[2]
11 Joan is an actuarial consultant who has operated as a sole trader for several years. She
has decided to bring Frank, a colleague, into the business.
Describe the advantages to Joan of a traditional partnership over a limited company

for the business arrangement with Frank. [5]
12 Describe the usefulness of bank overdrafts in managing a company’s working capital

requirements.[5]
13 Describe why quoted companies are required to disclose their diluted earnings per
share (EPS). [5]
14 Describe why users of financial statements should be careful not to place too much
emphasis on accounting ratios. [5]
15 Explain why an investment opportunity could be rejected when evaluated using the
shareholder value approach despite having a positive net present value (NPV). [5]
16 A long-established family company has grown to the point where it is about to seek
a stock market quotation. The members of the founding family, who presently own
100% of the equity, are considering converting their own shares into a special class
of shares so that they will control 51% of the votes, while retaining 30% of the equity
post-quotation.
Discuss the implications of creating this special class of shares. [5]
17 A listed company is planning a bond issue.
Describe the implications of attaching warrants to the issue in return for a lower
interest rate. [5]

18 A parent company has two subsidiary companies, both in distant foreign countries.
Explain the difficulties associated with interpreting this parent company’s

consolidated financial statements. [5]
19 The information provided below was obtained from the bookkeeping records of Barlo
plc on 30 June 2017.
(i) Prepare Barlo plc’s financial statements in a form suitable for publication:
• statement of profit or loss [9]

• statement of changes in equity [2]
• statement of financial position [4]
(ii) Describe the steps by which the estimated tax charge would have been
determined.[5]
[Total 20]
Barlo plc
Trial Balance as at 30 June 2017
£000 £000

Cash at Bank 428
Dividends paid 280
Loan interest 123
Loans 1,000
Marketing costs 2,457
Plant and equipment – accumulated depreciation 2,600
Production expenses 4,800
Production materials 11,080
Property – accumulated depreciation 4,270
Revenue 47,896
Sales salaries 2,463
Share capital 4,500
Share premium 1,200
Trade payables 509
Wages paid to production staff 3,100
—–————————–
65,393 65,393
—–————————–
————————––—
CT2 A2018–6
(1) Inventory was counted at 30 June 2017 and was valued at £1,950,000.
(2) Property is to be depreciated at 2% of cost and plant and equipment is to be

depreciated at 25% on the reducing balance basis.
(3) Corporation tax of £2,600,000 is to be provided for the year.

20 Mountain plc is a quoted company with a year end of 31 December. The directors
have traditionally published the financial statements in the second week of February
following the year end and have always announced the dividend for the year alongside
the publication of the financial statements.
Mountain plc’s dividend has grown by between 3% and 5% each year for the past
eight years.
During September 2016 the directors updated their projections of Mountain plc’s
financial position. They realised that it would probably not be prudent to increase the
dividend compared to last year. Indeed, it may be desirable to reduce the dividend by
5% compared to that for the year ended 31 December 2015.
Mountain plc continues to be profitable. However, a large loan has been negotiated in
order to fund expansion. If the market’s expectations concerning the dividend for the
year ended 31 December 2016 are met then the company’s projected gearing ratio will
be at the upper limits of the terms specified by the lender. The directors themselves
would be uncomfortable with a gearing ratio that was that high.
The directors are debating the best way to address the question of the dividend. Three
suggestions have been made:
• Announce the expected reduction in dividend immediately (i.e. in September

2016) with a clear explanation of the reasons.
• Wait and announce the reduced dividend, again with an explanation of the reasons,
at the publication of the financial statements (i.e. in February 2017).
• Maintain the dividend growth, but organise a rights issue in order to ensure that
there is sufficient equity to maintain the gearing ratio at an acceptable level.
(i) Explain why both the lender and Mountain plc’s directors would wish to set an
upper limit for the company’s gearing ratio. [8]
(ii) Discuss the advantages and disadvantages of announcing the proposed

reduction in the dividend in September 2016 or in February 2017. [6]
(iii) Discuss the advantages and disadvantages of conducting a rights issue to raise
equity in order to continue the trend of dividend growth. [6]
[Total 20]
END OF PAPER
CT2 A2018–8
EXAMINERS’ REPORT
April 2018

Core Technical
Introduction
Luke Hatter
June 2018
 Institute and Faculty of Actuaries

understanding of corporate finance including a knowledge of the instruments used
institutions.

methods, taxation, net present value and project appraisal and other topics, it has
of financial statements.

working is shown.
Many candidates performed very well in this exam. Question 19 which was on
preparation of financial statements was done exceptionally well with many
candidates achieving full marks for the accounts preparation part of the question.
Question 20 was not quite as well done; however there were some very good
answers.
In general, the multiple choice questions were well done as were many of the
short questions.
The area in which candidates’ performance was weakest was finance; this is often
the case with this exam.
Candidates were good at questions which mainly tested knowledge but were a
little weaker on application of knowledge to scenarios.
Having said that the results were in line with previous diets and many candidates
were excellent.
C. Pass Mark
Page 2
Solutions
Q1 D
Q2 C
Q3 A
Q4 B
Q5 C
Q6 A
Q7 C
Q8 B
Q9 D
Q10 A
Q1–10:
In general marks were reasonable for this section. A few candidates
achieved full marks and many achieved higher than 60%.
Q11 A partnership is a much simpler arrangement. [1]
The two parties simply need to agree a partnership arrangement and they can go into
business immediately. [1]
Frank can pay an agreed sum into the business as his capital and future profits can be
shared in accordance with the agreement. [1]
A limited company would require the requirements of the Companies Act to be met.
[1]
It could involve the need to prepare and file audited financial statements, depending
on the size of the business. [1]
The consultancy’s business dealings will be simpler for a partnership. [1]
For example, the lenders and creditors know that Joan and Frank are personally liable
for partnership debts. [1]
If they incorporate as a limited company then the company would be responsible for
the debts and some lenders might feel that they should take steps to protect
themselves, such as seeking personal guarantees from the directors. [1]
Page 3
This question was done well by many candidates with most showing an
understanding of partnerships. Some candidates did not compare
partnerships with limited companies and so received a lower mark.
Q12 Bank overdrafts have the advantage of flexibility. The business arranges an overdraft
facility and can use that as and when required to cover temporary cash deficits. [1]
That makes overdrafts ideal for companies that have large fluctuations in their bank
balances because they can use the overdraft facility to ensure that they are always able
to meet their commitments. [1]
No interest is paid on an overdraft unless the account is actually overdrawn, so it can

be cheaper to arrange an overdraft than to take out a term loan. [1]
The interest charged on overdrafts reflects the convenience that is being offered. [1]
If the account is overdrawn by a fairly constant amount then it would be cheaper to

take out a traditional loan and pay interest at a lower rate. [1]
There may also be an overdraft facility charge that is charged by the bank for offering
an overdraft, which would offset some of the savings because that is paid whether the
overdraft is used or not. [1]
The final problem with overdrafts is that they are repayable on demand. [1]
If the bank becomes nervous about the management of the account then it can
withdraw the loan, forcing the company to find funds from alternative sources at a
time that is likely to be very difficult. [1]
This question was done well by many candidates. The main reason for
getting a lower mark was not discussing the issues around overdrafts
being repayable on demand .
Q13 The earnings per share (EPS) ratio is a key measure of financial performance. It is so
important that it is the subject of an accounting standard. [1]
It is the basis for the price/earnings ratio, which is a key indicator of the market’s
views of a company. [1]
Any distortion could prove very misleading.
Some of the financial instruments that companies issue can have the effect of
permitting their holders to buy new shares at a preferential rate. [1]
Page 4
For example, a warrant attached to a bond issue or a share option granted to a director
could commit the company to increase the shares in issue without an equivalent
inflow of funds. [1]
The purpose of the diluted earnings per share is to inform the shareholders of the
impact of the exercise of any financial instruments so that they can be aware of the
possible impact on EPS and P/E. [1]
If there are large numbers of options or warrants in issue then the existing
shareholders interests could be badly diluted in the event of an exercise. [1]
There could be other effects, such as the cessation of interest payments on convertible
bonds after conversion to equity. [1]
This question was done well. Many candidates clearly understood EPS
and the impact on the price earnings ratio.
Q14 There is often a great deal of information in the absolute numbers that can be
overlooked in the event of an excessive focus on ratios. [1]
For example, revenue has increased since last year or a comparative company is much
smaller than the target. [1]
Dishonest directors focus on manipulating the ratios when they distort financial
statements. [1]
The results may seem satisfactory because they have been distorted in order to appear
so. [1]
For example, an accounting choice may have the effect of understating gearing or
overstating profitability. [1]
Ratios may require an understanding of the business before they make sense. [1]
For example, the liquidity of many retailers may seem unduly poor when considering
ratios, despite the fact that the cash flows through a typical retailer mean that such a
low ratio is perfectly satisfactory. [1]
This question was done very well by most candidates and marks were
high for this question. Some weaker candidates did not discuss
problems of directors being able to use different accounting treatments
when preparing financial statements.
Q15 The shareholder value approach bases the evaluation on the information that will be
available to the shareholders and also the issues that might affect their understanding.
[1]
Page 5
For example, a project may seem like a sound investment to the directors, but it would
be impossible to release all of the information that confirms that to the shareholders
because it would assist competitors. [1]
The shareholders may also be slightly sceptical of claims made by the directors
concerning their own performance. [1]
Finally, analysts or other industry experts may have expressed concern about the
potential repercussions of a particular type of investment. [1]
In theory, the directors should be willing to invest in any positive NPV project, but
they may be unwilling to do so if they fear that they will lose credibility in the
shareholders’ eyes as a result. [1]
This question was not done very well at all. Candidates were very
vague and very few understood the interaction between director’s
interests and shareholders’ interests. Few made the link with the
investment and shareholder value.
Q16 The most obvious implication is that the founders will retain control over the
company, even though they own a minority holding between them. [1]
That may be a significant psychological issue to the shareholders, who regard the
company as a “family business” even though it has grown to a size where it can seek a
quotation. [1]
The big question is whether this will impact on the marketability and price of the
shares. There may be concerns that the founders will run the company in a manner
that best suits them. [1]
Other shareholders may fear that they will be investing in a company with an
entrenched board that has been selected by the founders and that will pay little regard
to others’ interests. [1]
Conversely, the founders may be forced to use their controlling interest in a fairly
transparent and open way, otherwise they could impair the value of their own shares.
[1]
Also, the shareholders in a quoted company rarely have a great deal of influence at an
individual level, so they may be losing very little in terms of control because of the
founders’ shares. [1]
This question was reasonably well done. Candidates showed an

understanding of a family business but not of the links between
Page 6
shareholders and the founders. Generally, candidates gained enough

marks to narrowly pass.
Q17 Attaching a warrant essentially offers the bondholders two ways in which to benefit
from the investment, with a potential capital gain from the warrant. [1]
The capital gain will arise from the issue of fresh shares at the exercise price stated in
the warrant, so the company does not need to find any cash to make that payment. [1]
This is in contrast to the cash flows that are associated with paying interest and capital
on a traditional bond. [1]
If the warrant is exercised then the existing shares in issue will be diluted. [1]
In other words, the market value of each share will fall in response to the discount
implicit in the exercise price relative to the market value at exercise. [1]
The warrant may never be exercised, in which case there will be no long-term cost to
the entity or the shareholders. [1]
This question was done well by many candidates which was excellent.
There were a few candidates who did not seem to understand what
warrants are and just discussed bonds in a general manner.
Q18 The primary purpose of consolidated financial statements is to present the group as a
single economic entity. [1]
The parent-subsidiary relationship is defined in terms of control and the parent’s

directors are understood to exercise control over the entire entity. [1]
The problem arising with foreign subsidiaries is host country legislation may make it
difficult to exercise control in every respect. [1]
For example, it may be difficult to repatriate profits without incurring heavy tax
charges and so the extent to which the parent company can manage, say, the total
group bank balance may be called into doubt. [1]
In some cases, the synergies implied by the consolidated financial statements may not
be viable. [1]
For example, two factories in different countries may have to operate independently
because of distance and shipping costs and so there may be little scope for cost
savings through economies of scale such as bulk ordering. [1]
Page 7
This question was done badly with many candidates scoring only one
or two marks. The main problem was lack of knowledge and a failure
to answer what was asked. Many candidates turned this into a question
on translating foreign currency and the possible risks associated with
volatility in exchange rates, this was not what was asked..
Q19 (i) Barlo plc

Statement of Profit or Loss for the year ended 30 June 2017
£000
Revenue 47,896 0.5

Gross profit 24,736
Finance costs (123) 0.5
Income Tax Expense (2,600) 1
Barlo plc
Statement of Changes in Equity for the year ended 30 June 2017
Share Share Retained

capital premium Earnings Total
£000 £000 £000 £000
Opening balance 4,500 1,200 3,418 9,118

Dividends (280) (280)
Closing balance 4,500 1,200 13,851 19,551
0.5 0.5 1
Barlo plc
Statement of Financial Position as at 30 June 2017
Notes £000
Non-current assets
Property, plant and equipment 1. 17,300 1
Current Assets
Inventory 1,950 0.5
Page 8
Trade receivables 3,982 0.5

Bank 428 0.5
6,360
Total assets 23,660
Equity
Called-up share capital 4,500 0.5
Share premium account 1,200 0.5
Total equity 19,551
Loans 1,000 0.5
Current liabilities
Trade payables 509 0.5
Tax 2,600 0.5
3,109
Notes
1. Property, plant and equipment

Plant and
£000 £000 £000
Cost or valuation
At 30 June 2017 9,000 19,600 28,600
Depreciation
At 30 June 2016 4,270 2,600 6,870
180
Charge for year (1) 4,250(1) 4,430
At 30 June 2017 4,450 6,850 11,300
Net book value

At 30 June 2017 4,550 12,750 17,300
At 30 June 2016 4,730 17,000 21,730
Page 9
Workings
Cost of sales
Opening inventory 1,700 0.5
Production expenses 4,800 0.5
Production materials 11,080 0.5
Wages paid to production staff 3,100 0.5
Depreciation – property 180
Depreciation – plant and
equipment 4,250 0.5
Closing inventory (1,950) 0.5
23,160
Distribution
Marketing costs 2,457 0.5
Sales salaries 2,463 0.5
4,920
Admin
Administrative expenses 2,600 0.5
Directors' salaries 3,780 0.5
6,380
Max 15 marks
(ii) The starting point will be the reported profit according to the financial
statements. [1]
That figure will then be adjusted in accordance with the rules set out in tax
law. [1]
For example, there may be revenues and expenses that are not taxed or
permitted as deductions for tax purposes. [1]
There may also be allowances that do not appear in the financial statements
that must be deducted. [1]
For example, depreciation is not an expense for tax purposes, but capital
allowances are granted instead. [1]
Making these adjustments leaves taxable profit, which must be multiplied by

the appropriate rate, as set by government or tax authorities. [1]
Page 10
This question was done exceptionally well by most candidates. The

calculations and the set of financial statements were excellent and
many candidates scored full marks. The written part was also done
well.
Q20 (i) The lenders will be keen to avoid any loss in the event that Mountain is unable
to keep up with payments. [1]
Setting an upper limit on gearing will automatically leave a buffer of assets

that have been funded by the shareholders. [1]
In the event that the company defaults, those assets will provide a margin to
protect the lenders’ interests because the shareholders are not paid until all
liabilities have been repaid. [1]
Setting an upper limit for gearing deters further borrowing, which prevents the
existing lenders from having to share the company’s assets in the event of a
corporate failure. [1]
The directors will be keen to avoid getting too close to any upper limit in a
debt covenant because it could lead them into technical default. [1]
For example, a series of operating losses or a loss on the revaluation of

property could reduce equity while leaving debt unchanged. [1]
If that raises the gearing ratio beyond the upper limit then the lenders will have
the right to foreclose on their loans and that may prove catastrophic. [1]
Gearing also makes the profit for the year more volatile because the cost of
debt remains constant in the event of a downturn in operating profit. [1]
That may leave a much smaller profit after tax, with any fluctuations in
revenue and operating costs leading to a disproportionate decrease in earnings
attributable to the shareholders. [1]
(ii) It is debatable whether Mountain will be obliged to report this reduction in

advance, although it may well be prudent do so in order to prevent an
excessive reaction from the stock market. [1]
The danger of making an early announcement is that the shareholders may

believe that the directors are preparing them to expect further “bad” news as
the year unfolds. [1]
The share price may be depressed because of that inference and it could put
the directors in a very weak position in dealing with the shareholders if they
are viewed as acting defensively. [1]
Page
On the other hand, if the directors announce the change of policy at the last
minute then there could be a very negative reaction and the share price could
fall significantly. [1]
If the directors announce in September then they will have more time to
explain their reasoning and to enable the shareholders to get used to the idea.
[1]
The planned expansion should, hopefully, have increased the share price and
so shareholders who were counting on the usual dividend might appreciate the
extra notice so that they can find an alternative source of cash, such as selling
some of their shares. [1]
The longer period would also give the directors a longer opportunity to reverse
their decision and find a way to maintain the dividend if the shareholders’
response is unexpectedly violent. [1]
(iii) From a purely economic point of view, this is a highly illogical proposition.
Raising equity by means of a rights issue, purely to permit equity to be paid
out as a dividend seems rather contradictory. [1]
The rights issue will prove expensive once fees have been met and so there
will be a significant net cost. [1]
The financial press may portray this as a rather desperate act by the board that
implies a failure to understand the basics of financial management. [1]
If the rights issue is to proceed then the board could raise additional finance at
very little additional cost in order to restore some balance between debt and
equity or in order to provide a basis for further expansion. [1]
The fact that the board is prepared to take this extreme step would send a very
clear message to the markets that Mountain’s dividend will be maintained. [1]
That signal could prompt greater confidence in the company and so support
the share price. [1]
Shareholders are attracted to companies with known and stable dividend

policies because they assist them to plan their cash flows and also ensure that
their investments are tax-efficient. [1]
Part (i) was mixed; some candidates did this well and others very
badly.
Some candidates did not apply their knowledge very well to the
question. Many candidates discussed lenders and covenants but few
discussed the directors’ position on gearing.
Page 12
Part (ii) was not done very well and candidates did not seem to
understand the effects of an announcement. Many candidates passed
this part but few scored a high mark.
Part (iii) was done badly. Candidates gained marks by discussing
rights issues but few could discuss the dividend issue. A number of
candidates did not seem to realise that rights issues raised money and
most did not see how the rights issue would be seen by the stock
market.
Page
EXAMINATION

Core Technical
answer booklet.
supervisor.

question paper.

1 Which of the following statements about limited companies is correct?
A A company’s shareholders will never be personally liable for the company’s

obligations.
B A small company’s shareholders must be directors.
C Company directors can be shareholders.
D Companies can be managed by professional managers, whereas sole traders
and partnerships must be managed by their owners.
[2]
2 Which of the following describes the cost of trade credit?
A The cost of trade credit is included in the purchase price of the goods being
purchased.
B The cost of trade credit is known and transparent.
C Trade credit is provided free of charge.
D Trade credit liabilities can be settled late without consequence.
[2]
3 Which of the following statements is correct?
A A bank overdraft is more flexible than a fixed term loan.

B A bank overdraft must be repaid within a year.
C Banks cannot recall overdrafts because doing so would put customers out of
business.
D Banks generally secure overdrafts against specific assets.
[2]
4 A manufacturing company has been approached by a public limited company (PLC)

that wishes to apply for trade credit. Which of the following statements about the
applicant’s PLC status is correct?
A A PLC has a stock market quotation, making it more accountable.

B A PLC has a widespread shareholding, reducing the risk of conflicting
interests.
C A PLC is a larger entity than a private limited company.
D A PLC is not necessarily more creditworthy than a private limited company.
[2]
CT2 S2018–2
5 A quoted company’s shares have a nominal value of £1.00 and a market price of
£1.10. The company’s directors are considering a 1 for 5 scrip issue. Which of the
following statements is correct?
A The company will be unable to issue shares for cash in the immediate future.
B The marketability of the company’s shares will increase.
C The scrip issue will be forbidden by law.
D The share price will rise because scrip issues signal confidence.
[2]
6 Which of the following cases is a suitable situation in which a convertible security

might be issued?
A A business startup wishes to issue equity cheaply.

B A business startup wishes to reduce its cost of debt.
C An established business has a high gearing ratio.
D An established company has a low gearing ratio.
[2]
7 Which of the following best describes a ‘certainty equivalent’ used in project

appraisal?
A The expected value of an uncertain future cash inflow calculated using

probability theory.
B The fixed amount that the decision maker would accept as an alternative to an
uncertain expectation.
C The market price of an uncertain future cash flow, taking account of
observable values such as beta coefficients.
D The smallest amount that is anticipated from an uncertain future cash inflow.
[2]
8 Which of the following best describes the difference between basic and diluted
earnings per share (EPS)?
A Diluted EPS adjusts for any planned share issues that the directors plan to
implement during the next financial year.
B Diluted EPS adjusts for the impact of additional share issues that have been
made in the course of the year.
C Diluted EPS adjusts for the potential effects of instruments that grant the right
to purchase additional shares.
D Diluted EPS takes account of decreases in the share price that have occurred
during the financial year.
[2]

9 A manufacturing company had an operating profit of £30.0 million. Finance charges
were £1.6 million and tax was £2.5 million. The company’s share capital was
£80 million, retained earnings were £140 million and long term debt was £20 million.
Calculate the company’s return on capital employed (ROCE).
A 11.5%
B 12.5%
C 12.9%
D 13.6%
[2]
10 A company owns an item of equipment that cost £10,000 on 1 July 2010. The
equipment’s estimated useful life was 10 years, at which time its estimated scrap value
was £3,000. What is the depreciation charge on this equipment for the year ended
30 June 2018, assuming the straight line method of depreciation?
A £700
B £1,000
C £1,300
D £4,400
[2]
11 Explain how market forces might protect the shareholders in quoted companies from
agency problems. [5]
12 Explain the implications of margin payments for companies which use futures to
manage the risks associated with their finances. [5]
13 A quoted company is evaluating a potential investment opportunity.
Explain the relevance of opportunity costs to the evaluation of that opportunity. [5]
14 Discuss the assertion that a company’s optimal gearing ratio could be affected by its
line of business. [5]
15 The directors of Fentron plc, a major quoted company, are concerned that the
company’s price earning (P/E) ratio is low.
Explain the significance of the low P/E ratio to Fentron plc’s directors. [5]
CT2 S2018–4
16 Kate has invested her savings in equities issued by quoted companies. In September
2018 she received the annual report for the year ended 30 June 2018 of Contro plc, a
major manufacturing company.
Kate is concerned that the liquidity ratios calculated on the basis of Contro plc’s
statement of financial position look weak. She had similar concerns when she
received the 2017 annual report.
Discuss Kate’s concern. [5]
17 A company is profitable and it has increased its bank balance every year for the past
three years. Describe why it is necessary for such a company to prepare a cash flow
statement.[5]
18 Describe the purpose of the external audit of financial statements. [5]

19 The following information was obtained from the accounting records of Nolton plc, as
at 30 June 2018.
(i) Prepare Nolton plc’s financial statements in a form suitable for publication:
• statement of comprehensive income for the year ended 30 June 2018 [8]
• statement of changes in equity for the year ended 30 June 2018 [2]
• statement of financial position as at 30 June 2018 [5]
(ii) Discuss the proposition that the gain on the revaluation of property should be
taxed.[5]
[Total 20]
Nolton plc
Trial balance as at 30 June 2018
$000 $000
Cash at bank 1,238
Dividends paid 809
Loan interest 355
Loans 2,890
Management salaries 10,924
Manufacturing costs 13,872
Manufacturing materials – opening inventory 4,913
Manufacturing purchases 32,021
Plant and equipment – accumulated depreciation 7,514
Revenue 135,418
Sales commisisons 7,118
Selling expenses 7,101
Share premium 3,468
––––––– –––––––
188,985 188,985
––––––– –––––––
Further information
(1) All depreciation has been charged for the year and recorded in the relevant
accounts.
(2) Property was revalued at $16 million on 30 June 2018. This revaluation has
not yet been recorded in the accounting records.
(3) The closing inventory of manufacturing materials was counted and valued at
$5,274,000.
(4) The corporation tax charge has been estimated at $5,700,000.
CT2 S2018–6
20 Doron is an unquoted company which was founded 12 years ago and which has
grown steadily since. Its directors are considering an investment opportunity that will
increase the productive capacity of the business by 30%.
Doron was established using the savings of its three founders, who now comprise
the company’s board of directors. Each of the three founders owns one third of the
company’s equity. Doron’s growth has been funded using retained earnings and the
proposed expansion will be funded in the same way. The company has no debt. None
of the founders has any other significant personal assets apart from their shares in
Doron and their family homes.
The founders are considering more sophisticated approaches to the evaluation of

capital investment projects. They have asked you to determine Doron’s cost of equity.
They have established the following facts:
• The risk free rate is 4% per annum.

• The equity risk premium is 10% per annum.
• The beta coefficient of a quoted company which is in the same industry as Doron
is 1.4.
• The above quoted company has a debt:equity ratio of 0.6:1.
• The corporation tax rate is 20%.
(i) Calculate Doron’s cost of equity. [6]
(ii) Discuss the relevance of the rate that you calculated in part (i) to the evaluation
of the project to expand Doron. [7]
(iii) Discuss the relevance of the rate that you calculated in part (i) to the three
founders.[7]
[Total 20]
END OF PAPER

EXAMINERS’ REPORT
September 2018

Core Technical
Introduction
Mike Hammer
December 2018

understanding of corporate finance including a knowledge of the instruments
used by companies to raise finance and manage financial risk and to provide the
ability to interpret the accounts and financial statements of companies and
financial institutions.

statements and interpretation of financial statements. It also considers the basis
of the preparation of statements and the information needs of a variety of end
users of financial statements.

depending on whether figures obtained from tables or from calculators are used
in the calculations but candidates are not penalised for this. However, candidates
may lose marks where excessive rounding has been used of where insufficient
working is shown.
e
1. Many of the questions were answered very well. Question 19 in particular was
excellent with many candidates scoring full marks for the preparation of the set of
financial statements. There were one or two questions where the performance was
poor most noticeably question 20.
C. Pass Mark
The Pass Mark for this exam was 60 .
Page 2
Solutions
1 C [2]
2 A [2]
3 A [2]
4 D [2]
5 A [2]
6 B [2]
7 B [2]
8 C [2]
9 B [2]
• Correct answer = 30.0/ (80.0+140.0+20.0) = 12.5%
• No loans = 30.0/ (80.0+140.0) = 13.6%
• Deduct interest = (30.0-1.6)/ (80.0+140.0+20.0) = 12.9%
• Deduct tax = (30.0-2.5)/ (80.0+140.0+20.0) = 11.5%
10 A [2]
• Correct answer = (10,000 – 3,000)/10 = 700
• No residual value = 10,000/10 = 1,000
• Add residual value = (10,000 + 3,000)/10 = 1,300
• Net book value = 10,000 – (700 x 8) = 4,400
In general the questions 1-10 were answered well by most candidates.
11 Company directors will generally wish to maintain strong market prices for
shares and also bonds and other debt [1]
If the company is not as well managed as it could be then market prices can be
expected to drop. [1]
Price falls could signal the market’s dissatisfaction with the directors and could
result in a change to the directors’ behaviour in response. [1]
For example, if the shareholders are concerned that the directors will abuse their
positions as agents, the directors could view that as an incentive to send out a
positive signal. [1]
The directors could, for example, hire a more expensive and more credible audit
firm in order to demonstrate a commitment to transparency and honest [1]
Market prices may also give the directors an incentive to maximise shareholder
wealth. [1]
If, for example, they waste money on unnecessary expenses then the share price
will fall, creating the opportunity for a bidder to offer a premium in order to
acquire a controlling interest and correct matters. [1]
[Max 5]
Page 3
This question was answered well with many candidates scoring a high
mark.
12 Margin payments are used to protect market participants from the effects of
default. [1]
There is no reason for cash to change hands at the time of entering into a futures
contract until the contract’s maturity. [1]
The margin will always be sufficient to settle any liability and so participants
can be certain that they will receive everything that they are entitled to at
maturity. [1]
The margin payments will tie up cash, which could be a problem if a company
is an active player in the derivatives markets and has a number of positions
outstanding. [1]
No interest is paid on this deposit and so there could be a cost to tying up cash.
[1]
Derivatives can be volatile and so the margin can increase significantly and
unexpectedly. [1]
That could lead to difficulties in managing cash flows. [1]
[Max 5]
This question was done badly by most candidates. Most candidates

failed to demonstrate sufficient knowledge of derivatives and margin
calls. These finance questions are often the questions that are not done
very well.
13 Opportunity costs are relevant to any decision because they suggest that there
could have been benefits from an alternative course of action that is no longer
available. [1]
The most obvious example would be in choosing between two mutually exclusive
projects. [1]
Both could have positive NPVs, but one could have a higher NPV than the other
and so the lost opportunity could be a significant matter. [1]
Opportunity costs can be difficult to evaluate. [1]
First of all, there is no guarantee that all opportunities have been identified and
measured. [1]
Also, an accurate estimate could involve a significant cost in terms of time and
effort. [1]
Concerns that there could be unexplored opportunities could mean that projects
are delayed unnecessarily in order to further explore for alternatives. [1]
[Max 5]
Page 4
This question was not done very well but some candidates did score
high marks. Candidates were struggling to think of reasonable
examples and quoted examples that were not relevant.
14 The reason that gearing matters is that debt is cheaper than equity, but it has the
effect of enhancing the impact of any volatility in operating profit. [1]
The line of business will play a part in determining the underlying volatility and
so could make debt more or less attractive. [1]
A stable business with steady revenue has far less to be concerned about with
regard to gearing and so it can borrow more. [1]
Stability will also affect the availability of taxable profits against which to offset
the costs of additional debt. [1]
If a company risks making operating losses then there will be less scope for
benefitting from the tax relief available on debt. [1]
The line of business can also affect the availability of collateral. [1]
Debt will be even cheaper if it can be secured against readily realisable assets.
[1]
For example, a property company may own valuable real estate that generates
steady rental income. [1]
That business could afford to be far more highly geared. [1]
[Max 5]
This question was reasonable with many candidates giving good

answers. Some candidates struggled to come up with more than two or
three points.
15 A low P/E ratio implies a lack of confidence on the part of the stock market. [1]
That means that the share price is depressed in comparison to similar businesses
because shareholders will pay a smaller multiple of earnings. [1]
The directors will be concerned that the shareholders may be dissatisfied with
the return on their investment and so they may contemplate replacing the board.
[1]
It may be difficult for the directors to do much with respect to the P/E ratio. If
they can improve profits and financial performance then that might boost the share
price and the P/E. [1]
The only difficulty with that strategy is that it is to be hoped that the directors are
already doing their best to maximise profit. [1]
The share price will take account of management’s likely performance and so
there may be very little scope for improving the P/E ratio. [1]
A low P/E ratio may make it difficult to raise fresh equity. [1]
The shareholders may believe that issuing additional shares at a discount to the
current price will cause an unrealistic dilution of their shares. [1]
[Max 5]
Page 5
There were some weak answers in this question. Again, candidates

struggled to make more than one or two points. Some explanations
were confused and candidates seemed unsure whether a low or a high
P/E ratio was good and what the P/E ratio showed.
16 The first thing that Kate should consider is that Contro has had low liquidity
ratios for at last the previous year and possibly even longer. [1]
If the company survived a low liquidity ratio for more than a year then perhaps
it is reasonable to expect that it will continue to do so. [1]
The same argument could be applied to the fact that Contro is still in existence
and operating despite posting financial statements that suggest weak liquidity
two or more months ago. [1]
Liquidity merely has to be sufficient. Once working capital is large enough to
sustain operations there is no real advantage in it being even larger. [1]
Tying funds up in working capital is actually undesirable because it generates
no return. [1]
A further complication is that the working capital position can become
distorted at the year end because of creating accounting schemes such as
window-dressing. [1]
The company could have organised its payable and receivables so that they
appear to be well managed and that could have distorted the impression created
by the liquidity ratio. [1]
[Max 5]
This question was done well. Most candidates came up with good
points about working capital.
17 The cash flow statement reconciles the increase or decrease in cash for the year
to show the effects of inflows and outflows. [1]
Without the cash flow statement the increase or decrease in cash would be
potentially misleading. [1]
For example, it would always be possible to create a significant increase in cash
by taking out additional loans year after year. [1]
The cash flow statement highlights cash from operations, which is a significant
element of whether the company’s operations are sustainable. [1]
If the company cannot generate a surplus from operations then the business
itself will need to raise cash in unsustainable ways such as selling productive
assets. [1]
The cash flow statement also highlights the ways in which additional funds raised
during the year have been applied in terms of investment and expansion. [1]
[Max 5]
Page 6
This question was not done as well as some other questions. A

significant number of candidates got confused about whether it was the
same as the cash flow statement.
18 The external audit is necessary because the directors are responsible for the
preparation of the annual report. The shareholders rely on the financial
statements that it contains in order to evaluate the directors’ stewardship. [1]
In the absence of an audit, the financial statements would have little or no
credibility because the directors could be suspected of manipulating the financial
statements in order to give the shareholders a false reassurance. [1]
If the shareholders cannot trust the financial statements then there is a very real
sense in which they cannot trust the directors. [1]
The external audit addresses these concerns by expressing an opinion on the truth
and fairness of the financial statements. [1]
The auditor gathers evidence concerning the accounts and studies the resulting
figures in the financial statements. [1]
The auditor evaluates the accounting policies that have been applied in order to
decide whether they are acceptable. [1]
The audit report expresses a clear statement of the auditor’s opinion on the truth
and fairness of the financial statements. [1]
If that opinion is unmodified then the shareholders can rely on the figures [1]
[Max 5]
This question was not done very well, there were some very weak
answers. Few candidates came up with any ideas apart from the
shareholders would not be able to rely on the audit report. That is the
main problem but there are other stakeholders as well which could
have been mentioned as could misstatement of the financial statements.
19 (i)
Nolton plc
Statement of Comprehensive Income
for the year ended 30 June 2018
$000
Revenue 135,418 [0.5]
Cost of Sales (54,491) [2.5]
Gross profit 80,927
Distribution Costs (14,219) [1.0]
Administrative Expenses (18,438) [1.0]
Finance costs (355) [0.5]
Income Tax Expense (5,700) [0.5]
Page 7

Other comprehensive income
Revaluation gain 2,330
Total comprehensive income 44,545
Format [1.0]
Revaluation (either separate statement or simply in
statement of changes in equity [1.5]
Nolton plc
Statement of Changes in Equity
for the year ended 30 June 2018
Share Share Revaluation Retained
capital premium reserve Earnings Total
$000 $000 $000 $000 $000
Opening balance 13,005 3,468 3,000 9,879 29,352 [0.5]
Profit for the year 42,215 42,215 [1.0]
Dividends (809) (809) [0.5]
Gain on revaluation 2,330 2,330
Closing balance 13,005 3,468 5,330 51,285 73,088
Nolton plc
Statement of Financial Position
as at 30 June 2018
Notes $000
Non-current assets
Property, plant and equipment [1] 65,130 [2.0]
Current Assets
Inventory 5,274 [0.5]
Trade receivables 11,507 [0.5]
Cash at bank 1,238 [0.5]
18,019
Total assets 83,149

Equity [0.5]
Share premium account 3,468
Total equity 73,088
Page 8
Non-current liabilties
Loans 2,890 [0.5]
Current liabilties
Trade payables 1,471 [0.5]
Tax 5,700 [0.5]
7,171

Format [1.0]
Notes
1. Property, plant and equipment

Plant and
$000 $000 $000
Cost or valuation
At 30 June 2018 16,000 56,644 72,644
Depreciation
At 30 June 2018 - 7,514 7,514
Net book value

At 30 June 2018 16,000 49,130 65,130
Workings
Cost of sales
Purchases 32,021
Wages 8,959
Closing inventory (5,274)
54,491
Distribution
Commissions 7,118
Expenses 7,101
14,219
Admin
Expenses 7,514
Page 9
Salaries 10,924
18,438
Revaluation
Cost 26,010
Depreciation (12,340)
13,670
Gain 2,330
16,000
[Max 15]
(ii) The revaluation gain does reflect an increase in the shareholders’ wealth and, as
such, it could be taxed when the gain is realised. [1]
The problem with taxing the gain at the moment is that the gain itself is uncertain
and could change over time. [1]
In principle, the gain could reverse if the value of the property decreases. [1]
In that event, it would be necessary for the tax authorities to refund the tax already
paid on the gain. [1]
If the gains come and go then the tax system could become difficult to manage with
tax gains and losses being recognised as
[Total 20]
Part i was excellent many candidates achieved full marks. Part ii was
less well done but many candidates scored a pass. Very few candidates
mentioned taxation.
20 (i) Geared beta for comparative company = 1.4 [1]

Ungeared beta = B U = B g / [1 + ((1 - Tax Rate) x Debt/Equity)]
1.4/1+(1-0.2)x0.6/1)
=1.4/1+ 0.8x 0.6)
= 1.4/( 1+0.48)
= 0.946 [3]
Cost of equity = 4 + (0.946 x 10 = 13.46% [2]

[Max 6]
(ii) The rate reflects the systematic risks of this investment. [1]
As such, it takes account of the risks associated with this investment. [1]
The investment itself is really just an expansion of the business and so the project’s
risks are essentially the same as for the entity as a whole. [1]
The required rate of return on this project has been determined by observing the
rate required for similar equity investments. [1]
The starting point is the geared beta coefficient for a similar company that is quoted
and so has an observable beta. [1]
Page 10
That beta is then adjusted to remove the effects of gearing in order to ensure that it
reflects only the equity risks. [1]
The resulting rate may not be entirely appropriate. For example, the beta calculation is
based on historical observations. [1]
Expectations of risk may be different moving forward. [1]
[Max 7]
(iii) The rate resulting from these calculations reflects the return required by a shareholder
who holds a well-diversified portfolio. [1]
The three founders have put all of their wealth into this company and their family
homes, so their portfolios are not at all well diversified. [1]
The rate that we have determined ignored the effects of unsystematic risks and so it
understates the required rate of return that should be sought by the founders. [1]
Typically shareholders hold a range of investments and so the unsystematic risks
can be ignored because of the impact of diversification. [1]
For example, a change in selling prices might harm Doron, but it should, hopefully,
benefit at least one other company in the portfolio. [1]
The three founders each have only one other asset, namely their family homes.
[1]
Even if their homes increase in value to offset any loss in Doron, they cannot realise
those gains without selling their homes or borrowing against them. [1]
The danger is that Doron could invest in projects that offer insufficient return for the
risks that are being accepted by the founders. [1]
[Max 7]
[Total 20]
Part i was reasonably well done with many candidates scoring full
marks. Calculations are always done well and this was no exception.
Part ii and iii were very poor a number of candidates got confused
about systematic and unsystematic risk. This area is always very weak,
it would be good if candidates looked more closely at it during
revision.
Page 11
EXAMINATION
5 April 2019 (pm)
Subject CB1 – Business Finance

Core Principles
Time allowed: Three hours and fifteen minutes
answer booklet.
supervisor.
4. Attempt all questions. Answers to questions 1–10 should be indicated on the Multiple
question paper.
CB1 A2019 © Institute and Faculty of Actuaries

1 Which of the following statements best explains the role of the external auditor from
an agency perspective?
A The auditor enables the shareholders to rely on the financial statements

prepared by the directors.
B The auditor ensures that the company is well managed.
C The auditor provides the directors with independent advice on accounting and
financing matters.
D The shareholders can task the external auditor to examine particular areas of
concern.
[2]
2 Which of the following statements best describes the driver of the market price of a
quoted company?
A Expectations of future revenues.

B Expectations of future dividends.
C Historical trends of reported profits.
D Historical trends of dividend payments.
[2]
3 Martin has just been admitted to a long established business partnership. He has
bought 20% of the partnership equity, although he has not paid for this yet. He will
be entitled to 15% of the partnership profit. If the firm incurs any liability, what
proportion of that liability will be Martin’s legal responsibility?
A 0%
B 15%
C 20%
D 100%
[2]
4 When does a bondholder receive the nominal value of a bond?
A At the time of purchase.

B Annually.
C Whenever coupon payments are made.
D At maturity.
[2]
CB1 A2019–2
5 Which of the following statements describes the agency problem?
A
Agents may feel that they cannot trust their principals.
B
Agents may have insufficient authority to manage their principals’ affairs.
C
Principals may feel that they cannot trust their agents.
D
Principals may not have the necessary expertise to manage their own
businesses.
[2]
6 Charlie is a 100% subsidiary of the Corpo Group. Corpo is a major quoted

corporation. Charlie has serious cash flow problems and is struggling to meet its
immediate liabilities. Which of the following statements is correct?
A Corpo has no reason to support Charlie.

B Corpo is forbidden from supporting Charlie unless there is a contractual
reason for doing so.
C Corpo is required by law to support Charlie and settle the liabilities.
D Corpo will make a commercial decision as to whether it will support Charlie.
[2]
7 A parent company’s only asset is an £8 million investment in a 60% subsidiary. The

subsidiary’s assets are valued at £25 million. What value will be attributed to group
assets in the consolidated financial statements?
A £8 million
B £15 million
C £25 million
D £33 million
[2]
8 A newly formed company was funded by an equity injection, in which the

shareholders purchased a total of 10,000 £1 fully-paid shares for £2.50 each. Which
of the following figures will appear in the company’s statement of financial position?
Share capital (£) Share premium (£)

A 10,000 15,000
B 10,000 25,000
C 25,000 0
D 25,000 15,000
[2]
CB1 A2019–3 PLEASE TURN OVER

9 Which of the following statements best describes the purpose of the depreciation
charge?
A The depreciation charge creates a reserve for the replacement of assets when
they reach the end of their useful lives.
B The depreciation charge ensures that asset values remain realistic.
C The depreciation charge ensures that businesses obtain tax relief on the
consumption of assets’ values.
D The depreciation charge reflects the consumption of an asset’s value during the
period that benefits from that consumption.
[2]
10 Which of the following statements is a valid interpretation of an unmodified external

auditor’s report?
A The auditor has checked all transactions and balances and found everything to
be in order.
B The auditor has material misgivings about the truth and fairness of the
C The auditor is of the opinion that there are no material breaches of the
applicable accounting reporting standards.
D The directors have properly discharged all of their duties with regard to the
[2]
CB1 A2019–4
11 Discuss the proposition that businesses should take account of social responsibility
when conducting their operations. [5]
12 Describe whether preference shares should be treated as debt rather than equity when
evaluating a company’s gearing. [5]
13 Explain the implications of credit risk for entities which are considering entering into
interest rate swaps. [5]
14 Explain why top-down budgeting might be a more effective basis than

bottom-up for setting a consultancy firm’s annual budget for consultancy staff travel
and accommodation. [5]
15 The chief executive of a large actuarial consultancy has remarked that the head office
stationery cupboard is heavily stocked with basic office supplies such as pens, pencils,
paper clips and staples.
Discuss the implications of introducing a formal inventory management system to

reduce the value of the inventory held in the stationery cupboard. [5]
16 Discuss the proposition that the cash flow statement is a more suitable basis for
understanding a business’ performance than the statement of profit or loss.[5]
17 Discuss the implications of the fact that an actuarial consultancy’s statement of

financial position will typically make no reference to the value of staff. [5]
18 The development and implementation of International Financial Reporting Standards

(IFRS) is sometimes a contentious and prolonged process.
Describe the implications of this. [5]

19 Jill is the chief executive of Gearworks, a small company which manufactures
components for the car industry. Gearworks is a member of a trade association. The
latest issue of the trade association’s journal contains an article that summarises the
averages of the accounting ratios of 20 companies which are members of the trade
association. The article includes the following table of accounting ratios:
Average
Return on capital employed, excluding debt 26%
Return on capital employed, including debt 22%
Gross profit margin % 25%
Current ratio 2.1:1
Inventory turnover 42 days
Receivables turnover 50 days
The latest draft financial statements for Gearworks are summarised below:
Gearworks
Statement of profit or loss for the year ended 31 March 2019
€000
Revenue 1,200
Cost of sales (840)
–––––
Gross profit 360
Distribution costs (14)
–––––
–––––
Profit for the year 270

–––––
–––––
Gearworks
Statement of financial position as at 31 March 2019
€000
Current assets
Inventory 76
Cash at bank 11
–––––
237
–––––
Total assets 2,037

–––––
–––––
Share capital 500
–––––
1,362
Loans 600
Current liabilities
Trade payables 75
–––––

–––––
–––––
CB1 A2019–6
(i) Calculate each of the six ratios listed in the magazine article using Gearworks’
financial statements. You can assume that Revenue consists of credit sales. [6]
(ii) Comment on Gearworks’ performance in comparison to the industrial

averages.[9]
The draft financial statements provided above were prepared before the estimated tax
charge for the year had been calculated.
(iii) Explain how the inclusion of tax would have affected your understanding of
Gearworks’ performance. [5]
[Total 20]
20 Central is a major quoted company which manufactures highly specialised equipment

for use in the mining industry. Central has very limited scope for expansion. It
dominates the markets for its equipment and there is no real scope to develop sales in
alternative markets. Central has been highly profitable and it has amassed significant
retained earnings and has a large cash balance.
Central’s board has sought advice about the most efficient use of that cash balance.
Three main options are under consideration:
• The first possibility is that the cash might be retained for the foreseeable future, so
that Central has the necessary funding in place if any new opportunities arise.
• Alternatively, the board could use the funds in order to diversify into a completely
different line of business. Central’s cash reserves are large enough to fund the
creation of a significant business in another industry, such as leisure.
• Finally, Central could implement a share buyback under which Central would buy
shares back using the surplus funds.
(i) Discuss the implications of Central retaining the surplus cash in order to take
advantage of any new opportunity which might arise. [6]
(ii) Discuss the potential advantages and disadvantages of Central using the
surplus funds in order to diversify. [7]
(iii) Discuss the suitability of a share buyback to Central’s circumstances. [7]

[Total 20]
END OF PAPER
CB1 A2019–7
EXAMINERS’ REPORT
April 2019 Examinations
Subject CB1 - Business Finance

Core Principles
Introduction
The Examiners’ Report is written by the Chief Examiner with the aim of helping candidates,
both those who are sitting the examination for the first time and using past papers as a
revision aid and also those who have previously failed the subject.
circumstances may have changed if using these reports for revision
Mike Hammer
July 2019

Subject CB1 - Business Finance Core Principles - April 2019 - Examiners’ report
A General comments on the aims of this subject and how it is marked
1. The aim of the Business Finance Core Principles subject is to provide a basic
institutions.

of financial statements. The paper includes a small quantity of management
accounting mainly budgeting.

but candidates are not penalised for this.
B Comments on student performance in this diet of the examination
Performance was very good. Many of the questions were answered very well.
Questions 1-10 in particular were very good with a number of candidates scoring full
marks. There were one or two questions where the performance was poor most
noticeably questions 13, 18, 19 (iii) and question 20.
C Pass Mark
The Pass Mark for this exam was 60
CB1 A2019 @Institute and Faculty of Actuaries

Solutions for Subject CB1 - April 2019
1 A [2]
2 B [2]
3 D [2]
4 D [2]
5 C [2]
6 D [2]
7 C [2]
• A Parent’s investment in sub
• B Parent’s investment + 60% of sub’s assets
• C Correct answer: sub’s assets, with nothing from parent because its only
asset is cancelled on consolidation
• D Parent’s investment + 100% of sub’s assets
8 A [2]
• A Correct answer: equity shares = 10,000 x £1.00 and …
share premium = 10,000 x £1.50
• B - Values share premium at £2.50/share
• C - Values share capital at £2.50
• D - Values share capital at £2.50 and double counts premium
9 D [2]
10 C [2]
[Total 20]
Questions 1-10 were answered very well. Many candidates scored a very high mark which
was excellent.
11 Social responsibility can be discussed from an ethical perspective. Business

operations affect numerous stakeholders in a host of different ways. [1]
For example
• Externalities such as emissions can create health hazards and reduce the
quality of life. [1]
• These externalities often arise because it would cost more to process
Emissions before releasing them into the environment. [1]
• Companies often have to make quite delicate decisions because they may
be operating in jurisdictions in which there is little or no regulation to force
them to behave responsibly. [1]
• Companies should also consider social responsibility from an economic
perspective. [1]
• It may be that companies can reduce costs by taking advantage of lax
legislation, perhaps by establishing factories in countries where low pay is
permitted. [1]
• Such behaviour can affect revenues because customers may be unwilling to
buy a product that has been manufactured in such conditions. [1]
[7, Max 5]

This question was answered well. With many candidates commenting on the increase in
share price for socially responsible companies.
12 Preference shares generally combine characteristics of both debt and equity and
so there can be a debate about their treatment in ratio analysis. [1]
From a practical point of view, they carry a fixed rate of dividend, which has a
similar impact on cash flows to borrowing. [1]
These fixed payments increase the risks borne by equity shareholders in exactly
the same way as the fixed payments associated with debt. [1]
Preference shares may not carry the same degree of compulsion to pay fixed
finance charges as debt. [1]
The directors may be permitted to suspend a preference dividend payment if they feel
that the company cannot afford it, but there will be reputational damage (at least). [1]
The suspension of a preference dividend may also lead to other penalties, such as
the suspension of ordinary dividends. [1]
In some cases, preference shares may be designed so as to carry contractual rights
to dividends and the repayment of the face value on a specified date. [1]
Preference shares have been implicated in creative accounting schemes. [1]
[8, Max 5]
This question was done well with most candidates showing good understanding of the
differences between ordinary and preference shares and discussing debt very well.
13 The essence of an interest rate swap is that two parties agree that they will recreate
the effects of fixed and variable rate liabilities. [1]
In other words, if the variable rates are higher than fixed then the fixed rate
borrower will reimburse the variable rate borrower, and vice versa. [1]
That creates the effect of the fixed rate borrower having a variable rate loan and
the variable rate borrower is now effectively fixed. [1]
The parties to a swap do not actually exchange obligations. [1]
In other words, there is no direct obligation arising from a counterparty falling
behind on its loan payments. [1]
The most immediate problem would be that any unpaid sum due from the
counterparty could be forfeited in the event of a financial collapse. [1]
The long-term risk of a financial problem would be the possibility that the swap
will collapse and will either leave an unwanted fixed/variate rate liability. [1]
That could require a fresh swap to be negotiated with a new counterparty. [1]
Credit risk may be mitigated by conducting detailed credit checks on the
counterparty to the swap. [1]
The intermediary who organises the swap may take deposits or other advance
payments to mitigate credit risk. [1]
[10, Max 5]

This question was poorly answered. Candidates did not demonstrate much knowledge of
interest rate swaps.
14 Top down budgeting involves budgetary targets being set by senior managers
and imposed on more junior managers and staff. [1]
Junior managers can feed back and raise concerns, but the budget is essentially
set by the time that they first see it. [1]
The budget for staff travel and accommodation will have a direct impact on the
comfort and convenience enjoyed by staff when they travel for work. [1]
Under bottom up budgeting, consultancy staff might be inclined to set budgets that
permit them to spend more, so that their trips are more enjoyable. [1]
For example
• they might set budgets with the intention that they will use first class rail
travel and business class when they fly. [1]
Top down budgeting would make it easier for senior management to set an
appropriate standard, allowing for the need to avoid false economies. [1]
There could, for example, be an argument that journeys that exceed a certain length
would be unduly tiring by economy class. [1]
[7, Max 5]
15 The most immediate impact would be that inventory levels would decline,
releasing cash in the process. [1]
Unfortunately, the contents of the stationery cupboard are unlikely to be worth
enough to release a material amount of cash, and so it is debatable whether the
effort would be justified. [1]
Having a formal inventory management system would enable the consultancy to
optimise its inventory of stationery, but that might involve all staff in additional
time and effort because inventory levels would have to be monitored. [1]
Requiring staff to update records to show that they had taken a packet of staples
Or a pen would distract them from their real work. [1]
Holding smaller quantities of stationery would create the risk of shortages. [1]
Running out of basic commodities, even if it happened infrequently, could cost
more than the costs created by holding excessive quantities. [1]
Arguably, the system of maintaining healthy levels of inventory and replenishing
well before they run out is the most efficient way to manage this asset. [1]
Insisting on an improvement could undermine the CEO’s credibility. [1]
[8, Max 5]
Most candidates showed an understanding of cost versus benefit when managing

stationary inventory.

16 The cash flow statement helps readers to understand the cash flows arising from
operations. [1]
Given that shareholder wealth is essentially a function of net cash flows, the
cash flow statement could be linked to shareholder wealth. [1]
Cash flows are also relatively objective measures of performance. [1]
The amount of cash on hand at the beginning and end of each financial year can
be checked against bank statements. [1]
Accruals-based financial statements leave scope for errors and creative
accounting. [1]
Measuring performance in terms of cash flows could, however, create scope
for dysfunctional behaviour. [1]
If the directors do not, for example, invest in new assets then the operating cash
inflows will increase in the short to medium term, although that could then lead to a
shock when the assets finally need replacing. [1]
[7, Max 5]
Candidates demonstrated reasonable understanding of the cash flow statement and why it
is useful.
17 The most obvious implication is that it is unclear what resources are available to the
management team. [1]
The consultancy’s most significant and most valuable asset is its staff. [1]
Anyone considering the strength of the business from the outside will also be left
with the impression that it has little or nothing with which to generate revenue. [1]
This could also mean that there is a tendency for costs incurred in order to improve
the workforce’s capability is written off as a cost rather than capitalised as an asset.
[1]
Money spent on, say, training or staff development will not be added to the asset of
human resources. [1]
There could be wider implications for the credibility of the financial statements of an
entity in this industry. [1]
If stakeholders cannot see key facts such as the value of staff then they may wonder
what other omissions there might be. [1]
That could limit the value of the financial statements in any negotiations that occur.
[1]
[8, Max 5]
This question was done well.
18 The first implication is that the body of IFRS may constantly seem to be incomplete
and in the process of changing. [1]
Accounting standards are necessary to ensure that all companies prepare their
financial statements in a consistent manner so that their results can be compared. [1]

Accounting standards are necessary to ensure that companies can prepare their
financial statements in as consistent a manner as possible from one year to the next,
so that their year-on-year results can be meaningfully compared. [1]
If accounting standards are not updated promptly because of controversies over
accounting then there will never be a settled body of accounting standards. [1]
That will damage the IASB’s reputation which will, in turn, undermine the
credibility of financial statements. [1]
The fact that accounting standards are sometimes disputed could also affect
the accounting treatments themselves. [1]
The need to obtain the support of preparers and other interested parties could
mean that a technically sound accounting practice is set aside in order to reach a
compromise. [1]
[7, Max 5]
The answers to this question were weak. Candidates did not demonstrate clear
understanding of the problems of standard setting.
19 (i)
Gearworks Average
Return on capital employed, 270/1,362 = 20% 26% [1]
excluding debt
Return on capital employed, 324/(1,362+600) = 17% 22% [1]
including debt
Gross profit % 360/1,200 = 30% 25% [1]
Current ratio 237/75 = 3.2:1 2.1:1 [1]
Inventory turnover 76/840 x 365 = 33 days 42 days [1]
Receivables turnover 150/1,200x365 = 46 days 50 days [1]
[Total 6]
(ii) The most important issue is that Gearworks is delivering a less attractive return on
investment, with both ROE and ROCE either 5 or 6 points below the industry
average. [1]
Taking this at face value, the company’s board has been inefficient, although it
could be argued that the company’s size means that it is unable to achieve the
same economies of scale as are available to some other industry members. [1]
Larger companies will be able to invest in more efficient technology or to spread
operating costs over a higher unit output. [1]
Gearworks has a higher gross profit % than average. It is unlikely that this has
been achieved through more effective procurement activities because it is a small
company. [1]
It may be that Gearworks has been forced to charge a higher margin than average in
order to cover costs, which has probably constrained revenue and also ROCE. [1]
Gearworks has a high current ratio, which implies that the company is very solvent.
[1]
This also means that resources are being tied up in current assets that are unlikely to
yield any return and so this will be contributing to the poor ROCE and ROE. [1]

The concerns about the current ratio are contradicted slightly by the fact that
Gearworks turns over both inventory and receivables more rapidly than average. [1]
The high current ratio may, therefore, imply that excessive cash is being held (which
seems unlikely) [1]
or that the company is settling trade payables too quickly, which would require
further ratios to investigate. [1]
[10, Max 9]
(iii) Calculating the tax charge would give profit after tax as a measure of
performance. [1]
That would enable ROCE to be based on pre or post-tax values. [1]
It could be argued that a post-tax statistic could be a more relevant measure of
overall performance because it is part of the board’s responsibility to manage the
tax expense and to use any legal methods available to them to minimise the tax
charge. [1]
The tax charge would also create a liability for Corporation Tax in the statement
of financial position. [1]
That would create a potentially confusing impact on liquidity ratios because the
amount would be payable within months of the year end, but would not be as
urgent as the trade payables. [1]
Liquidity ratios could be less attractive, despite the fact that the company has not yet
taken the necessary steps to raise cash in order to fund the payments. [1]
[6, Max 5]
[Total 20]
Part (i) was done very well with most candidates gaining a high mark. Part (ii) was
reasonable with many candidates understanding what the ratio analysis showed. Part (iii)
was weak with poor understanding of how taxation would change the ratios.
20 (i) The most immediate implication is that the shareholders will start to wonder why
the company has this resource lying idle and not generating any revenue. [1]
This asset has arisen from the company’s past profits and so it has essentially
been funded by equity, which is an expensive form of finance. [1]
Raising equity and leaving the resulting assets lying unproductive could discourage
the shareholders. [1]
The fact that the directors have no plans for this cash surplus suggests that they
cannot justify the balance in any communications with shareholders. [1]
There does not appear to be a realistic prospect of any project getting under way
to put this cash to effective use. [1]
The shareholders’ return on equity will be diluted by this unproductive asset. [1]
There could even be a possibility that the capital markets will discipline the
directors through the market for corporate control. [1]
Any potential bidder could afford to pay a premium over the present share price
in order to obtain control. [1]
That premium could then be recouped using the cash to invest in positive NPV
projects. [1]
[9, Max 6]

(ii) Diversification would reduce the total risk associated with running Central. [1]
That could be desirable to the board members, who may feel nervous about using
the available funding to further increase the company’s investment in the mining
industry. [1]
The board members may be reluctant to invest in existing or related lines of business
because their careers could be at risk if an investment subsequently goes wrong. [1]
Investing in an unrelated line of business will, hopefully, mean that Central can
maintain a steady stream of profits. [1]
The disadvantage of diversification is that the shareholders will derive no benefit
from that. [1]
They can and should already be diversifying for themselves in their wider context
of their personal investment portfolios. [1]
If the shareholders wish to diversify for themselves then they can buy shares in
leisure industry businesses. [1]
There is a danger that Central’s management team will make such an investment
and then mismanage it and so waste the shareholders’ money. [1]
[8, Max 7]
(iii) A share buyback would be a suitable arrangement for returning the cash. The obvious
alternative would be a large dividend payment. [1]
Paying a dividend would risk creating tax problems for those shareholders who
have high taxable incomes. [1]
A share buyback could be structured so that shareholders could opt to be included
and there may be sufficient willing participants to focus the repayment on those
who would benefit from a tax perspective. [1]
The buyback would essentially involve a capital gain in most cases. [1]
There could be further issues associated with market psychology. [1]
Paying out a large dividend could be reported in the press as an example of
corporate and market greed. [1]
A buyback would at least create the impression that the shareholders are sacrificing
part of their investment in order to participate. [1]
There would also be little or no risk of creating an expectation that the dividend
payout has increased and will run at a higher rate going forward. [1]
[8, Max 7]
[Total 20]
[Paper Total 100]
Part (i) was done very well with most candidates gaining a high mark. Part (ii) was a little
weaker, candidates struggled to discuss diversification and apply it to the question. Part
(iii) was also a little weak with candidates demonstrating a poor understanding of share
buybacks.

EXAMINATION

Core Principles
answer booklet.
supervisor.
4. Attempt all questions. Answers to questions 1–10 should be indicated on the Multiple
question paper.
CB1 S2019 © Institute and Faculty of Actuaries

1 Which of the following statements provides the best explanation for why non-financial
factors ought to be considered when evaluating an investment project?
A Non-financial factors can be more easily understood.

B Non-financial factors can give insights into upside risks.
C Non-financial factors are the primary driver of shareholder wealth.
D Only anticipated net cash flows matter.
[2]
2 Which of the following is a valid basis for weighting debt and equity in order to
calculate the weighted average cost of capital (WACC)?
A Book value of debt and book value of equity.

B Book value of debt and market value of equity.
C Market value of debt and book value of equity.
D Market value of debt and market value of equity.
[2]
3 The expected outcome of a project has been estimated using two approaches. The first
approach was to predict the outcomes based on five sets of assumptions with given
probabilities. The second approach was a Monte Carlo simulation that has been run
many thousands of times. The results from both approaches are significantly different.
A The investment decision should be based on the more pessimistic of the two
predicted outcomes.
B The approach based on five sets of assumptions can be more readily reviewed
and checked for reality.
C The Monte Carlo simulation is more sophisticated and is, therefore, more
reliable.
D The project should be abandoned because there is no way to predict the
outcome with any certainty.
[2]
4 What is the strongest argument in favour of setting a common hurdle rate across a
company for all projects?
A All projects in the same industry have the same risk.

B The decision rule is clear and can be applied consistently.
C A common rate will ensure consistency when capital rationing is in effect.
D The hurdle rate is not a material factor in evaluating a project.
[2]
CB1 S2019–2
5 You have been asked to determine the internal rate of return (IRR) of a project that
has an initial cash outflow, followed by seven years of net cash inflows. The project’s
net present value was + $500,000 when determined at 11% and – $500,000 when
determined at 16%.
Which of the following statements concerning the project’s IRR is correct?
A The IRR is approximately 13.5%.

B The IRR is exactly 13.5%.
C The IRR is greater than 16%.
D The IRR is less than 11%.
[2]
6 Which of the following best describes the responsibility of the external auditor?
The external auditor:
A expresses an opinion on the fair presentation of the financial statements.

B prepares the financial statements.
C reassures the directors that the financial statements present fairly.
D reassures the shareholders that the company is a sound investment.
[2]
7 A company owns property that cost $5.0 million and has been depreciated by
$1.5 million. The property has recently been revalued at $8.1 million. What figure
will appear in the revaluation reserve in respect of this asset?
A $1.6 million
B $3.1 million
C $4.6 million
D $6.6 million
[2]
8 A company makes sales on credit of $100,000 every month. Trade receivables

generally take 50 days to pay. What would be the impact on cash of changing the
terms of trade so that receivables were settled after 40 days?
A The bank balance will increase immediately.

B The bank balance will increase over the next 40 days.
C The bank balance will increase over the next 50 days.
D The bank balance will increase within a month.
[2]
CB1 S2019–3 PLEASE TURN OVER

9 Why is it generally expensive to grant a cash discount for prompt settlement of trade
receivables?
A Credit customers will be unlikely to take up the cash discount.

B Granting a discount will involve significant and complicated bookkeeping
entries.
C It is not possible to incorporate the cost of cash discounts into selling prices.
D The discount must be compounded, generally revealing a high annualised cost.
[2]
10 Which of the following statements best distinguishes a budget from a forecast?
A budget:
A has a future orientation.

B involves active planning.
C may involve feedback against actual.
D requires an understanding of the entity.
[2]
11 Discuss the need for formal and transparent procedures to determine the policy for
directors’ remuneration in a quoted company. [5]
12 The partners who own an actuarial consultancy are considering moving to a larger and
more prestigious office, despite the fact that doing so has a negative net present value
on the basis of a five-year cash flow projection.
Discuss the possibility that the move might be justified on the basis of strategic fit. [5]
13 Recommend, with reasons, the most appropriate means of mitigating health and
safety risks associated with opening a branch office in another country that has, until
recently, been politically unstable. [5]
14 Discuss the advantages and disadvantages of showing non-current assets in the

statement of financial position at their fair value rather than cost less depreciation. [5]
15 Explain the purpose of integrated reporting as an alternative to traditional financial

reporting.[5]
16 Describe the potential conflict between relevance and reliability in the selection of
accounting policies. [5]
CB1 S2019–4
17 Describe the purpose of the non-controlling interest figure in a consolidated statement
of financial position. [5]
18 The directors of an actuarial consultancy are concerned about the high costs
incurred for administration, including costs of administrative staff, associated office
accommodation costs and other costs such as IT.
Discuss the suitability of zero-based budgeting for managing the consultancy’s

administrative costs. [5]
19 Roundspar, a manufacturing company, needs a new piece of equipment that will cost
$10m. A potential lender has requested the following asset cover ratios:
Total assets less current liabilities less intangible assets

Loan capital plus prior ranking debt
$60m – 2m – 11m
=
$10m + 12m
= 2.1 times
and
Total assets less current liabilities less intangible assets

Total loan capital
$60m – 2m – 11m
=
$44m
= 1.1 times
Both ratios take account of the increased assets and additional debt arising from the
transaction.
Roundspar currently has a $12m mortgage loan that is secured against property valued
at $18m.
The new loan will be secured by a floating charge.
(i) Explain why each ratio would be relevant to the potential lender. [6]
(ii) Discuss the advantages and disadvantages to the lender of excluding intangible
assets from the asset cover ratio. [8]
(iii) Discuss the potential agency conflicts that might arise between the interests of
Roundspar’s shareholders and the providers of debt finance. [6]
[Total 20]

20 Tarvale is a major quoted company that manufactures timber products. The company
has suffered a major setback during the past few months. The company’s largest
supplier was unable to meet Tarvale’s timber requirements because volcanic activity
close to the supplier’s forests caused forest fires which severely disrupted transport
routes. Tarvale was able to purchase timber from alternative sources, but paid
much more than usual because Tarvale receives a substantial discount from its usual
supplier.
Most of Tarvale’s board members are concerned that the shareholders will blame
them for allowing the company to become so heavily dependent on a single supplier.
The Production Director disagrees, though, on the basis that the Capital Asset
Pricing Model (CAPM) suggests that shareholders diversify, which protects them
from unsystematic risks. The volcanic disruption is an unsystematic risk and so the
shareholders were protected. In any case, the Production Director had considered the
risk of disruption due to the volcano and had concluded that the risk of an eruption in
any given year was less than 5%.
Tarvale has a high gearing ratio. The Production Director proposes that the board
should determine the company’s ungeared beta in order to determine whether the
shareholders are earning a satisfactory return on their investment, despite the costs
associated with the volcano.
(i) Discuss the Production Director’s argument that holding diversified portfolios
would have protected Tarvale’s shareholders from the volcanic disruption and
so the shareholders will not blame the board. [8]
(ii) Discuss the Production Director’s proposition that the risk had been evaluated
and so the board should not be criticised. [7]
(iii) Discuss the respective relevance of Tarvale’s geared and ungeared betas to its
shareholders.[5]
[Total 20]
END OF PAPER
CB1 S2019–6
EXAMINERS’ REPORT
September 2019
Subject CB1 - Business Finance:

Core Principles
Introduction
Mike Hammer
December 2019

Subject CB1 (Business Finance - Core Principles - September 2019 - Examiners’ report
1. The aim of CB1 subject is to provide a basic understanding of corporate finance

including a knowledge of the instruments used by companies to raise finance and
manage financial risk and to provide the ability to interpret the accounts and
financial statements of companies and financial institutions.
2. This paper examines basic business finance including raising funds by a variety of
methods, taxation, net present value and project appraisal and other topics, There is
also a section on management accounting including budgeting, it has both
calculations and essay type questions on these topics. The paper also examines
financial reporting including preparation of the main financial statements and
interpretation of financial statements. It also considers the basis of the preparation
of statements and the information needs of a variety of end users of financial
statements.
the calculations but candidates are not penalised for this. However, candidates may
lose marks where excessive rounding has been used or where insufficient working
is shown.
B. Comments on student performance in this diet of the examination.
1. Candidates performed reasonably well in this exam. Question 19 which was on

three areas of accounting was answered reasonably well but not as well as Q19 in
April. Question 20 was on risk and geared and ungeared betas and other finance
issues was done reasonably well and much better than in April.
2. As usual there were some excellent candidates at the top who scored very high
marks.
In general, the multiple choice questions were well done as were many of the short
questions.
3. There were a few areas of this exam where candidates did not perform as well as
expected. These were in the areas of integrated reporting, relevance v reliability,
zero based budgeting and finance.
4. Candidates were good at questions which mainly tested knowledge but were a little
weak on application of knowledge to scenarios
5. Having said that the results were reasonable but the pass mark was lower than in
recent diets of this subject.
C. Pass Mark
CB1 S2019 @Institute and Faculty of Actuaries

Solutions for Subject CB1 - September 2019
1 B [2]
2 D [2]
3 B [2]
4 B [2]
5 A [2]
The residual NPVs are the same, + or -, so the approximate IRR is roughly half way from
11% to 16% (i.e. 13.5%).
Graphing NPV at various points shows a curve, so IRR will not be exactly 13.5%.
6 A [2]
7 C [2]
A - 8.1 - 5.0 - 1.5 = 1.6
B - 8.1 - 5.0 = 3.1
C - Correct answer - 8.1 - (5.0 - 1.5) = 4.6
D - 8.1 - 1.5 = 6.6
8 B [2]
Receivables before change = $1,200,000 x 50/365 = $164,384
Receivables after change = $1,200,000 x 40/365 = $131,507
Decrease = cash inflow = $32,877
The effects of the change will be felt within the first 40-day cycle.
9 D [2]
10 B [2]
[Total 20]
X Questions 1-10 were answered well by many candidates.

11 The directors can negotiate and sign contracts on the company’s behalf without
seeking the shareholders’ permission. [1]
That could enable the directors to abuse their powers by granting one another
excessive salaries and other benefits. [1]
Allegations of greed have undermined shareholder confidence in the directors in the
past, with concerns that board members are paying themselves excessive and
unjustified amounts. [1]
Formal policies set out the basis on which remuneration packages are decided and so
there is, at least, a mechanism for setting remuneration. [1]
The shareholders will also be keen to understand how board remuneration motivates
the directors. [1]
For example, a basic salary may not offer an incentive to excel because the rewards
will be the same regardless of performance. [1]
Performance related rewards can also raise problems if they encourage dysfunctional
behaviour. [1]
For example, directors’ share options can create an incentive to manipulate share
prices so that options are in the money when they are exercised. [1]
The need for disclosure is required in order to comply with the requirements of
codified rules relating to corporate governance. [1]
Transparency will also help to reduce agency conflicts. [1]
[10, Max 5]
This question was answered well. Many candidates scored a high mark for this question.
12 Arguably, all negative NPV projects should be rejected on the basis that they are
expected to reduce the partners’ wealth. [1]
The NPV criterion is, however, restricted to the cash flows that have been identified
and predicted by the decision makers. [1]
It could be argued that moving to a larger office will create scope for expansion that
might be complicated if the partnership does not take the new office. [1]
The additional space will enable the firm to employ additional consulting staff
without undue concern about accommodating them. [1]
A more prestigious office may also help to attract new clients, who may regard the
building as evidence that the firm is professional and successful. [1]
It would be reckless to take such potential revenues into account in a formal NPV
calculation because they cannot be predicted with any certainty. [1]
The new premises create a potential for upside risk that may be lost if the partners do
not proceed. [1]
The justification will depend on the NPV. If it is proportionate to the possible upside
then it could be viewed as an investment in future scope for adding new business. [1]
The five-year timescale may be too short a period to reflect the full potential for such
a long-term project. [1]
[9, Max 5]
X This question was answered well by most candidates.

13 The most suitable response would be to reduce uncertainty as far as possible by

studying the present political climate and taking advice from reliable sources as to the
risk. [1]
The entity will have to establish that any managers and staff who are asked to live and
work in the new host country will not be at risk because of violence or corruption. [1]
It may be possible to seek advice from the home government, assuming that it has an
embassy or consulate in the country. [1]
The risk may be avoided to some extent by engaging local staff to fill as many posts
as possible. [1]
That will reduce the number of home country nationals who will be put at risk. [1]
It will also ensure that the locally hired staff will be available to brief their
counterparts and will be able to offer informed advice. [1]
The company could arrange for practical support, such as arranging accommodation
and transportation between home and office. [1]
That would ensure that staff are based in safe locations and that they are protected
during their commute. [1]
The company might organise suitable insurance cover for all staff. [1]
Insurance would not, of course, mitigate the risk itself, but it would protect the
company from the financial costs. [1]
[10, Max 5]
X Candidates generally scored high marks in this question.
14 Valuations can be far more relevant than cost less depreciation. [1]
The shareholders will be informed of the value of the resources for which the
directors should be accountable. [1]
Lenders will have a much clearer understanding of the value of any assets that have
been offered or pledged as security. [1]
The main disadvantage of reporting values is that they may be difficult to determine
with any reliability. [1]
There are very few assets that have an open and observable market value. For
example, property values may be affected by the precise location of the property and
issues affecting local markets. [1]
Furthermore, values might fluctuate over time, with increases and decreases
introducing volatility into reported results. Such volatility will be distracting if the
entity has no intention of selling the assets concerned. [1]
A credible valuation, using independent experts, would be relatively expensive to
carry out. [1]
Recognising any increase in value will result in a higher depreciation charge, which
will reduce profit. [1]
[8, Max 5]
Answers to this question were mixed some very good and some quite poor.
Candidates quite often came up with points on valuations being subjective and expensive,
which was good.

15 Integrated reporting is intended to give stakeholders a clearer understanding of the

entity and its management. [1]
The company publishes significant amounts of supplementary information on factors
such as strategy, stakeholder relationships and other factors. [1]
The overall effect is to give users of the integrated report a much clearer
understanding of the entity’s direction, so that they can better understand risks and
rewards. [1]
To an extent, many stakeholders would have conducted research into the issues
disclosed in the integrated report for themselves and so some of the information
offered may be a little redundant. [1]
The difference is that the integrated report communicates the directors’
understanding, which may help stakeholders better understand the company’s
direction. [1]
Independent research may still yield benefits, but the board’s understanding of the
company’s position and environment may be difficult to determine without a detailed
report. [1]
Integrated reporting frequently gives a clear insight into the sustainability of the
company’s operations. [1]
Company’s often use the integrated report to highlight their impact on the
environment. [1]
[8, Max 5]
This question was answered badly with most candidates being unsure what integrated
reporting is. Many candidates thought it was something to do with consolidations. This is
a new topic and is covered in the core reading but answers were disappointing.
16 Relevant information tends to be more subjective, partly because it is frequently

future oriented. [1]
For example, shareholders in a small company that makes expensive sports cars may
be keen to know the market value of inventory rather than its cost because that will
give a better idea of the value that has been created during the year. [1]
Predicting the market value will be a subjective process because it will have to take
account of the possibility of disruptions such as the launch of new models by
competitors. [1]
Reliable information is generally backward looking and so it can be validated and
audited. [1]
That does not necessarily mean that it lacks relevance. For example, costs are
historical, but the cost of an asset that has recently been acquired can be relevant to
certain decisions. For example, selling prices should cover the costs of replacing
inventory. [1]
Even subjective estimates can often be verified to some extent, so that users can be
reassured that the information is sufficiently reliable for their purposes.
[1]
[6, Max 5]
This was answered very badly with few candidates demonstrating knowledge of the topic.

17 Non-controlling interest arises in group accounts to recognise the fact that some or all
of the group’s subsidiaries are not wholly owned. [1]
By definition, the parent has control over each subsidiary, but any non-controlling
shareholders who remain have a claim to their portion of the subsidiary’s equity. [1]
The value of that equity reflects the non-controlling shareholders’ claim to the
retained earnings arising since the subsidiary joined the group. [1]
The total reported for non-controlling interest enables the parent company
shareholders to see the extent to which the equity in the group’s subsidiaries is funded
by external shareholders. [1]
The non-controlling shareholders have no specific rights to the group itself or the
parent company and so care has to be taken in interpreting the non-controlling
interest. [1]
It acts as a reminder that one or more subsidiaries have external shareholders who
may have rights that could constrain decisions that might benefit the group at the
subsidiaries’ expense. [1]
[6, Max 5]
This question was answered reasonably well by many candidates. Although many answers
lacked detail and were a little vague many achieved a passing score.
18 If costs seem excessive then zero based budgeting would force the directors to review
them in turn, with a view to establishing whether they might be dispensed with. [1]
Traditional budgets are often incremental, with little questioning of the need to
eliminate costs that may no longer be required. [1]
Working through each cost in turn, perhaps by starting with a list of the administrative
staff posts and discussing whether it remains necessary, will give the directors an
opportunity to eliminate costs. [1]
Zero based budgeting can be difficult to implement in a meaningful way because
certain costs would be difficult to eliminate. For example, eliminating or reducing the
costs of heating the offices may be impractical and it would be a waste of time to
discuss it. [1]
Also, staff may be discouraged by such severe cost cutting, particularly if they fear
that their jobs are at threat. [1]
A full zero based budgeting exercise would be time consuming and expensive in itself
and those costs may not be justified. [1]
[6, Max 5]
This is a reasonably new topic for CB1 and it was not answered very well. Many
candidates said it started with a blank sheet but after that had little to say. Some candidates
did not address what was asked but gave a general answer on zero based budgeting and
did not mention admin costs, heat and light or any other expenses.

19 (i) The first ratio reflects the likelihood that the lender’s principal will be repaid in the
event that the company goes into liquidation. [1]
The numerator shows the assets that will be available for sale in the event that the
company fails and the denominator shows the total that will have to be repaid in order
for the lender to be repaid in full. [1]
If Roundspar fails then $12 million will have to be repaid to other creditors before the
lender receives anything. Overall, that means that Roundspar’s assets cover the
lender’s position 2.1 times. [1]
The alternative ratio is a variation of the gearing ratio. Rather than focussing on the
specific protection for the lender, it indicates whether Roundspar is likely to get into
difficulty. [1]
If Roundspar is highly geared then it will have calls on its cash flow, which could
increase the risk of it running into difficulty. [1]
The lender will not be particularly concerned about the company’s ability to repay the
whole $44m that it owes, but it will be inconvenient and possibly expensive if
Roundspar defaults. [1]
(ii) The most immediate advantage of disregarding intangibles is that they may have little
value in the event that the company fails. [1]
For example, intangibles could include the cost of acquiring the rights to the trading
name “Rounsdspar”. [1]
That trading name will probably lose most of its value in the event that the company
is wound up. [1]
A further advantage of excluding the intangibles is that their values are likely to be
highly subjective and so it is unclear how much of the $11m will be realised in the
event of a failure. [1]
The disadvantage of excluding intangibles is that it could lead to unduly pessimistic
loan evaluations, which could cost the lender the opportunity to make a profitable
loan. [1]
The intangible assets have a value to the shareholders, which will give them an
incentive to support the company in order to maintain their value. [1]
They are also a source of revenue (if they have any value at all), which will reduce the
risk of corporate failure to some extent. [1]
Some intangibles, including licences and patents, can be sold on the open market and
can have considerable value. [1]
(iii) Under normal circumstances, the lenders have very little ability to influence or
manage the company’s decisions. [1]
The loan agreement might give them certain rights if the company is late in making a
loan payment or fails to achieve agreed benchmarks, such as a maximum acceptable
gearing ratio. [1]
Provided the company does not breach any of those conditions, it can continue
without interference from the lenders. [1]
The interests of the shareholders and lenders could conflict in situations where the
shareholders were in danger of losing their investment and were keen for the company
to take risks in the hope of resolving the problem. [1]
If the company faced collapse then the shareholders would be keen to pursue a risky
strategy that offered the possibility of recovery. If the strategy succeeds then the
shareholders will benefit and they will be no worse off if the strategy fail. [1]

The shareholders might also be keen to withhold information from the lenders in the
event that the lenders might be entitled to protect themselves by foreclosing. [1]
For example, a loss on revaluation might be suppressed because it would put the
company in default of a gearing restriction. [1]
[7, Max 6]
[Total 20]
Part (i) was answered very well.

Part (ii) was answered less well and most answers were brief and lacked detail. A number
of candidates seemed unclear what the intangibles were in this case and had difficulty
answering the question.
Part (iii) had some weak answers as candidates were unclear what lenders should be aware
of and what influence they could have.
20 (i) The Production Director’s argument rather misses the point about the purpose of
diversification. Holding a diversified portfolio implies that shareholders can look
forward to a relatively steady return from the portfolio as a whole, with poor
performances from some investments being compensated by stronger returns from
others. [1]
Looking forward, diversification will protect Tarvale’s shareholders from
unsystematic risks. [1]
That would not justify reckless behaviour by the Board because Tarvale’s
shareholders will be adversely affected by this loss, even if they are diversified [1]
Diversification does not mean that the shareholders are guaranteed an offsetting gain
to deal with every loss. [1]
The capital markets will not necessarily perceive the logic underlying the Production
Director’s arguments. It may appear that the company has been mismanaged and that
could cause the share price to fall. [1]
The shareholders may be affected by perceptions that the company is risky, even if
the risks are not as serious as generally believed. [1]
The Board had a responsibility to identify significant risks and to take appropriate
action in response. [1]
Diversification is really a matter for the shareholders to manage. They have a right to
expect that the directors will act responsibly in order to mitigate all risks responsibly.
[1]
(ii) The fact that the risk of a volcanic eruption has been evaluated is a partial defence
because it demonstrates that the Board was aware of the threat and had considered it.
[1]
It could be argued that the Board had determined that the most appropriate response to
the risk was to accept it, perhaps on the basis that a more rigorous mitigation strategy
would have been too expensive. [1]
The fact that the volcano erupted does not, in itself, show that the response to the risk
was inadequate. [1]
It would be more appropriate for the shareholders to consider whether they would
have paid more to source timber from a source that was not threatened by the same

volcano, if they had been aware of the threat when the decision to accept the risk was
taken. [1]
The evaluation does not, in itself, excuse the Board entirely. Firstly, it could have
been argued that the low prices charged by this supplier reflected a high probability of
problems. [1]
If the risk was of the order of 5%, as implied by the Production Director, then that is
quite a high likelihood of a loss on this scale. [1]
There could also be arguments that the Board had misunderstood the threats and that
they had understated the impact that this threat would have. [1]
(iii) The ungeared beta is relevant to the shareholders because it indicates the systematic
risks associated with the company’s business operations. [1]
The beta should be relevant to, say, evaluate the systematic risks associated with any
expansion of the business. [1]
Or it could be helpful as a basis for comparison with a similar company in order to
establish whether systematic risks could be managed more effectively. [1]
The geared beta allows for the effects of borrowing. Gearing increases systematic risk
and so the geared beta reflects the overall systematic risk associated with investing in
the company. [1]
The geared beta will give an idea of the total systematic risk being accepted, both
because of the business and its funding. [1]
The difference between geared and ungeared beta will give an idea of the impact that
any changes to financing might have to the entity’s systematic risk. [1]
[6, Max 5]
[Total 20]
[Paper Total 100]
Part (i) was answered reasonably well although there were some poor answers. This
question was about diversified portfolios, some candidates seemed very unsure about how
to answer this question.
Part (ii) This was answered well by many candidates and was about risk and directors
behaviour.
Part (iii) This was about geared and ungeared betas, this can often be a problem area for
candidates but was answered quite well this time.

EXAMINATION
06 May 2020 (am)

Core Principles

1 Why would the directors of a quoted company spend more than necessary on their
external audit?
A Auditors are greedy and will overcharge if they can.

B Company directors do not understand the pricing of audit services.
C Finance directors are frequently recruited from the external audit firm.
D To signal that the financial statements are credible in the face of agency
concerns.
[2]
2 How can the directors of quoted companies deal with the different risk preferences of
the many shareholders who have invested in their companies?
A By aiming to maximise market capitalisation

B By maximising expected returns, regardless of risk
C Through minimising risk as much as possible
D By seeking feedback from shareholders.
[2]
3 Which of the following would be a suitable duty for a non-executive director?
A Development of a business plan to support application for bank funding

B Participation in the selection of executive directors
C Selection between major mutually exclusive projects
D Selection of the principal supplier for key raw materials.
[2]
4 An actuary has prepared a computer model to simulate a complex project’s outcome.

The model’s logic has been reviewed carefully. The following table shows the
simulation results.
Average net
Number of runs
present value
5,000 +$50 million
10,000 –$70 million
20,000 +$2 million
What should be concluded from these results?
A Projects should not be evaluated on the basis of simulations.

B The decision to proceed should be based on the return of +$2 million.
C The required rate of return has been set too high.
D The simulation needs to be run many more times.
[2]
CB1 A2020–2
5 A company has $10 million available for investment. It is considering investing in
three individual investment projects:
Initial investment Net present value

Project One $4 million $9 million
Project Two $2 million $3 million
Project Three $7 million $11 million
What would be the opportunity cost of investing in Project One?
A $2 million
B $5 million
C $11 million
D $14 million.
[2]
6 The directors of a company are considering investing in a machine that will cost
$38 million. The machine will have a useful life of 5 years. The cost of capital is 10%
p.a.
The directors have determined that the annual capital charge of this machine is $10
million. The machine will generate revenues of $14 million and will require annual
running costs of $1.5 million.
A The annual capital charge method indicates that the company should invest in
the machine because it will increase shareholders’ wealth.
B The annual capital charge method indicates that the company should invest in
the machine, but it does not indicate that the investment will increase
shareholders’ wealth.
C The annual capital charge method indicates that the company should not invest
in the machine because doing so will reduce shareholders’ wealth.
D The annual capital charge method indicates that the company should not invest
in the machine, even though the investment will increase shareholders’ wealth.
[2]

7 Why would the directors of a quoted company pay close attention to the company’s
draft financial statements?
A The directors are unlikely to understand the financial statements.

B The external auditor cannot be trusted to check the draft financial statements
properly.
C The information obtained from the company’s internal management accounts
is unreliable.
D The shareholders will use the financial statements to evaluate the directors’
stewardship.
[2]
8 A quoted company made a significant bond issue. Which of the following statements
is correct?
A The company’s beta coefficient will remain unchanged after the bond issue,
until the passage of time indicates whether beta has increased or decreased.
B The company’s beta coefficient will increase after the bond issue.
C The company’s beta coefficient will decrease after the bond issue.
D The company’s beta coefficient will only change if the company continues to
earn taxable profits after the bond issue.
[2]
9 How should an investor evaluate a security that has a beta value of zero?
A The security has zero risk.

B The security has an extremely high risk.
C The security offers a return that is not affected by movements of the market as
a whole.
D The security offers a zero return.
[2]
10 Which of the following best explains the fact that a consolidated statement of
financial position does not show a figure in respect of non-controlling interest?
A All of the subsidiaries are wholly owned by the parent company.

B None of the subsidiaries were acquired as going concerns.
C The group has no associated undertakings.
D The parent company has a widespread shareholding.
[2]
11 Explain the role of share prices in managing the behaviour of the directors of quoted
companies. [5]
CB1 A2020–4
12 The directors of ABC, a manufacturing company, evaluate projects using the payback
method. The directors are reluctant to switch to the net present value criterion and are
justifying their reluctance on the basis that the company has grown steadily since it
was founded 20 years ago.
Describe the relevance of the payback criterion to ABC. [5]
13 Explain the most appropriate ways of mitigating the reputational risks associated with
manufacturing and selling unhealthy food products, such as sweets. [5]
14 International Accounting Standards identify relevance as a desirable characteristic for

accounting information.
Describe whether accounting for property, plant and equipment at historical cost less
depreciation results in a valuation that lacks relevance. [5]
15 The United Nations defines sustainable development as ‘development that meets the
needs of the present without compromising the ability of future generations to meet
their own needs’.
Describe the difficulties associated with preparing a useful sustainability report for a
quoted company. [5]
16 Describe the relevance of International Financial Reporting Standards (IFRS) to

external auditors. [5]
17 An actuarial consultancy has prepared a cash flow forecast that shows that its bank
overdraft will increase steadily for 6 months, reaching a final figure of $87,000. Fees
from scheduled work will then start to flow in and the overdraft will decrease steadily
for 6 months until it is cleared. Unfortunately, the consultancy’s overdraft limit is
$50,000.
Explain how the consultancy should deal with its expected cash flows. [5]
18 A private company’s directors collectively own 100% of the company’s share capital.
For the past 3 years the company has paid an annual dividend equal to the annual
profit after tax.
Describe the implications of this dividend policy. [5]

19 Parent is a major quoted financial services company. It has a wholly-owned
subsidiary (Sub) that provides actuarial services to the other companies in the group.
Sub employs 94 qualified actuaries, plus 110 support staff. These numbers include 18
senior managers who are responsible for Sub’s management. Sub operates from an
office space within Parent’s head office.
Sub’s annual running costs are approximately $20 million, including an annual
internal charge of $2.5 million made for the use of the office space.
Sub’s senior management team has held an initial meeting with Parent’s Board to
discuss the possibility of a management buyout of the subsidiary by its senior
managers. Parent’s Board has agreed, subject to the following terms:
 The senior management team would pay $4 million for Sub.

 Sub would continue to provide all of Parent’s actuarial services under contract for 4
years, at an annual fee of $16 million. That contract would be renegotiated at the end
of year 4.
 Sub would be permitted to remain in the office space for 18 months without charge
but would be required to vacate the space at the end of that time.
 Sub would retain all the IT equipment and office furniture.
The senior management team could raise $1.8 million by investing $100,000 each
from their personal savings and by remortgaging their homes. They will each take
equal shares in the company and will retain 100% ownership between them.
(i) Discuss the advantages and disadvantages of this management buyout

arrangement to Sub’s senior management team. [8]
(ii) Describe the advantages and disadvantages of this management buyout

arrangement to Parent. [6]
(iii) Discuss whether it would be preferable to permit Sub’s other employees to

buy shares in the company. [6]
[Total 20]
CB1 A2020–6
20 Vonder is a major quoted company that manufactures tyres. The company’s annual
report for the year ended 30 June 2020 was released yesterday. The following
summary was included in the business pages of this morning’s newspapers:
Current year Last year

$ billion $ billion
Operating profit 48 44
Book value of equity 362 351
Market capitalisation of equity 447 427
Non-current liabilities 350 240
The newspaper article referred to the fact that the figures take account of a new
factory that cost Vonder $150 billion when it took possession in May 2020. The
purchase was paid for using debt that was raised on the date of acquisition.
Vonder’s CEO is concerned that the company’s shareholders will misunderstand the
company’s Return On Capital Employed (ROCE) for the year ended 30 June 2020.
(i) Explain the relevance of the book value and the market capitalisation of equity
for the calculation of Vonder’s ROCE. [8]
(ii) Discuss the implications of the investment in the new factory for Vonder’s
ROCE. [7]
(iii) Discuss the implications of a misunderstanding of ROCE for Vonder’s share

price. [5]
[Total 20]
END OF PAPER
CB1 A2020–7
EXAMINERS’ REPORT
April 2020
Subject CB1 - Business Finance - Core Principles
Introduction
Mike Hammer
July 2020


Subject CB1 - Business Finance - Core Principles - April 2020 - Examiners’ report

institutions.
taxation, basic management accounting, net present value and project appraisal and
other topics, it has both calculations and essay type questions on these topics. The
paper also examines financial reporting including preparation of the main financial
the preparation of statements and the information needs of a variety of end users of

the calculations but candidates are not penalised for this. However, candidates may
lose marks where excessive rounding has been used or where insufficient working
is shown.
B. Comments on student performance in this diet of the examination.
Many candidates performed very well in this exam. The MCQs were done quite
well. Some of the short response questions were done very well but some of the
questions were poorly answered. Performance in Question 20 was poor. The
question was divided into three parts and they were all done quite badly. The
question was on company performance and the ROCE ratio in particular.
The area which candidates’ performance was weakest was finance, this is often the
case with this exam.
Candidates were good at questions which mainly tested knowledge but were a little
weak on application of knowledge to scenarios.
Having said that the results were in line with previous diets and many candidates
were very good.
C. Pass Mark
The pass mark for this exam was 57
774 candidates presented themselves and 462 passed
CB1 A2020
Solutions
Q1 D [2]
Q2 A [2]
Q3 B [2]
Q4 D [2]
Q5 C [2]
Q6 A [2]
Q7 D [2]
Q8 B [2]
Q9 C [2]
Q10 A [2]
[Total 20]
Q1-10 were done well by many candidates. A few candidates achieved full marks which
was excellent.
Q11
 Share prices reflect the market’s expectations of future cash flows, which is a
reflection of both the business and the manner in which it is being managed [1]
 If the directors’ management is dishonest or incompetent then the share price will
decrease, which may prompt questions about the quality of management [1]
 Share prices are generally driven by informed and competent investors, but all
shareholders can interpret the decline of the share price as “bad news” and can
consider whether a change of direction might be required [1]
 The ultimate sanction for poor share price performance is that the company will be
regarded as a prime candidate for takeover [1]
 Poorly performing directors could find that a predator believes that it would be
potentially profitable to offer a premium over the share price in order to take control
and to manage the company more efficiently [1]
 Directors may receive shares as part of their remuneration packages. If so, they will
have a direct incentive to act in the shareholders’ interests in order to maximise the
value of their personal shareholdings [1]
[6, Max 5]
Many candidates demonstrated a good understanding of the factors that drive share
prices. Candidates were less aware of the link between share price and directors’
performance. There were, however, some very good answers.
Q12
 The payback criterion does not make a full allowance for the time value of money [1]
 or for risks and rewards associated with cash flows after the payback period has
elapsed [1]
 The criterion is not, therefore, necessarily consistent with the basic criterion of
maximising shareholder wealth [1]
CB1 A2020
 Despite that, it is realistic to suggest that a project that has a short payback period is
likely to have a positive NPV and so it may be a satisfactory basis for identifying
satisfactory projects [1]
 ABC may also operate in a relatively low-risk industry and so have a low required
rate of return on projects, in which case there is less risk of payback being misleading
[1]
 The fact that the criterion has been used for many years does not, in itself, mean that it
has been successful. For example, the company could have invested in a number of
negative NPV projects without that ever being noticed [1]
 The company will also be unaware of the opportunity cost of investing in projects that
had lower NPVs than alternatives that could have been selected instead [1]
[6, Max 5]
There were many excellent answers to this question. A few candidates gave very generic
answers on why payback was poor or why NPV was a better method these answers did not
gain high marks but usually passed.
Q13
 Realistically, the only effective mitigation would be to reduce the risk. The risk can
only be avoided by switching to a completely different range of products that do not
have any health risks [1]
 There are no practical ways to transfer the risk and accepting the risk appears to be
unacceptable [1]
 The main problem is likely to be the reputation risk arising from the sale of a product
that may be harmful if consumed to excess. The manufacturer might attempt to
mitigate that risk by educating consumers and encouraging them to behave
responsibly [1]
 The company can reduce the risk by encouraging buyers to be responsible when
buying and eating sweets [1]
 Promoting the products as treats that are not to be eaten in place of nutritious food or
eaten in excessive quantities will, at least, demonstrate that the company is aware of
the risk and is keen to address it [1]
 It may also be possible to reduce the risk by making portions smaller or adjusting the
recipe so that the sugar content is reduced [1]
[6, Max 5]
This question was done badly. Some candidates spent a lot of time discussing health and
safety issues rather than the problems of sugar content. Candidates did not mention
mitigation in any detail. Few candidates discussed social responsibility.
Q14
 Relevance can only be judged in the context of the decisions that are to be based on
the figures [1]
CB1 A2020
 Cost less depreciation will not necessarily offer even a rough estimate of the market
value of an asset and so it will be little help in, say, informing a lender’s decision
about asset values as collateral [1]
 Similarly, knowing the book value will be of little help in deciding whether to retain
an asset or sell it on the open market or scrap an asset rather than repairing it [1]
 The issues affecting property may differ from those involving plant and equipment
because property tends to have a longer life. Valuing a building at cost less
depreciation could result in a figure that is so badly out of date that it has very little
relevance [1]
 The book value may not reflect the market value or economic value of the assets, but
it does enable some allowance to be made for the availability of assets when
calculating ratios [1]
 Comparing, say, ROCE for two companies in the same industry will be aided by the
inclusion of book values because the figures will, at least, reflect the scale of the
respective companies’ investments [1]
[6, Max 5]
This question was also done badly by many candidates.

Candidates did not understand relevance and reliability and where they did they failed to
make any link to assets.
This question required some knowledge of financial reporting and few candidates
demonstrated this in their answers.
Q15
 The factors that need to be taken into account in measuring the impact on the
environment are not always fully understood or agreed [1]
 Areas such as the implications of emissions or the need to manage climate change are
often the subject of controversy. That can make it difficult to measure and report on
sustainability [1]
 The question of whether an entity can be viewed as managing resources responsibly
when it is consuming natural resources that may be irreplaceable is complicated [1]
 This is also an area in which companies may feel exposed because they may be
encouraging criticism of their behaviour through admitting to their environmental
impact [1]
 For example, attempts to offset carbon emissions are often viewed as inadequate
because it may take some time for the offset to actually occur in the face of emissions
that are occurring in the short term [1]
 Social and political differences can mean that companies will always face criticisms
that their reports are deliberately misleading [1]
[6, Max 5]
Many candidates passed this question as they managed to think of three points that were
relevant. Few candidates achieved a high score.
CB1 A2020
Q16
 External auditors have a responsibility to report on whether financial statements
present fairly [1]
 In doing so, they must form an opinion on whether the financial statements have been
prepared in a manner that justifies an unmodified opinion. That can require delicate
professional judgement because of the potential for disagreement over accounting
treatments [1]
 The IFRS provide a benchmark against which fair presentation can be measured. It
would certainly be difficult to argue that a fair presentation was being offered if the
accounts did not comply with IFRS [1]
 That can strengthen the auditor’s position in the event of any disagreement with the
directors because any controversial accounting treatments that do not comply with
IFRS can be rejected [1]
 The IFRS also provide the auditor with some justification for an audit opinion. If the
opinion is ever challenged by a user of the financial statements then the auditor can
argue that the financial statements present fairly in terms of the recognised accounting
standards [1]
 The ability to justify an audit opinion in those terms may be sufficient to reduce the
risk of reputational damage to the auditor [1]
[6, Max 5]
This question was not answered very well. A number of candidates did not read the
question properly and wrote about how IFRS help people prepare financial statements
and did not discuss the auditor. The answer should have been about why IFRS are useful
to auditors not generic points about the benefits of IFRS.
Q17
 The neatest response would be to take the forecast to the bank immediately and to
admit that there is a danger that the overdraft will exceed the $50,000 limit. The
consultancy could then seek an increase in the overdraft limit, even on a temporary
basis [1]
 If the bank can see that the company anticipates returning to a positive balance then it
might be prepared to grant this request, avoiding the problem altogether [1]
 If the bank is unwilling to increase the overdraft then the consultancy might find it
easier to take out a short-term loan that would cover the period of the deficit [1]
 Alternatively, the management team should review the forecast carefully to determine
whether there are any payments that might be delayed [1]
 The scheduled purchase of equipment or replacement of company cars might be put
off until after the anticipated return to a positive balance [1]
 That would, at the very least, reduce the overdraft to below the $87,000 maximum
and, hopefully, even keep it below the $50,000 limit [1]
[6, Max 5]
This question was done quite well by candidates.

Many candidates demonstrated a good understanding of cash flows.
Many candidates achieved a passing score and a good number of candidates scored full
marks.
CB1 A2020
Q18
 The most immediate threat is that the company could run out of cash, making this
policy inherently unsustainable [1]
 The fact that profit has been earned does not mean that there is sufficient cash
available to pay the entire amount as a dividend [1]
 The company could, for example, have recognised revenues that are still to be
collected and so the dividend payment could reduce the bank balance. It could also be
necessary to use cash for purposes other than operating costs. Assets could require
replacement [1]
 The lack of retained earnings could mean that the company has insufficient funding to
invest in attractive opportunities that arise. The company will either have to borrow or
seek an injection of equity from the directors, out of their personal wealth [1]
 The fact that the company is wholly owned by its directors reduces the risks of major
problems [1]
 There is no need to maintain the dividend in order to signal confidence because the
directors already have a full understanding of the business and will be able to put any
decrease in dividend into context [1]
[6, Max 5]
This question was in the area of finance which is often the weakest subject area. Few
candidates could write much for this question and many did not achieve a passing score.
Many candidates did not realise the company was quite small and all the shares were
owned by the directors. This made a huge difference to the answer and these candidates
did not pass this question.
Q19 (i)
 The most immediate advantage is that the managers are no longer restricted to their
salaries. They will share the profits made by Sub, which could be significantly greater
[1]
 The deal gives them the security of $16m of revenue every year, which is a good start
for a new business venture because they don’t need to go out and look for business
[1]
 They will be working for a known business and will understand what is being
expected of them [1]
 The directors will have rent-free accommodation for the first 18 months of their
operations on an independent basis, which will reduce the disruption of relocating
staff and will save costs [1]
 The significant personal borrowings will be a serious concern. The failure of the
business could leave them in serious financial difficulties [1]
 They will have to reduce running costs from $20.0m - 2.5m = $17.5m to $16.0m
immediately, which could prove difficult [1]
 They will undoubtedly have to make former colleagues redundant in order to achieve
this, which may be uncomfortable and even distasteful [1]
 It may be more difficult to achieve those savings than they expect because it is
reasonable to imagine that Parent has already considered all practical ways to reduce
costs while maintaining quality [1]
CB1 A2020
 It will also be necessary to start looking for new premises almost immediately in order
to be ready to relocate [1]
[9, Max 8]
(ii)
 The biggest advantage is that the business will receive an inflow of $4m. That will
improve cash flows, even if it is not a huge sum in comparison to the size of the
Group as a whole [1]
 Parent will also benefit from the cost savings associated with the fixed annual fee to
Sub being lower than the operating costs that would otherwise be incurred [1]
 When the contract is set for renewal in four years, the company will have a massive
advantage in terms of bargaining power and may be able to reduce costs even further
[1]
 This arrangement will enable the company to retain the services of its existing
actuarial team, rather than risking the disruption of outsourcing to a third party who
may prove to be incompetent [1]
 There could be disadvantages, though. The MBO team will be under pressure to
reduce costs, which could have an adverse impact on the quality of the service [1]
 The need to keep the contract will also give the actuaries a good reason to avoid
owning up to any errors or omissions, which could prove costly in the long run [1]
 The new entity might also start looking for additional work from third parties, which
could be a further distraction [1]
[7, Max 6]
(iii)
 Restricting shares to the 18 senior managers could have the effect of demotivating
other managers and staff, who would wish to own a stake in the company [1]
 There would be no significant loss of control if the senior staff took, say, 3% each
which would give them 54% in total and so they would retain control [1]
 The additional equity would reduce the need for the founders to find the whole $4m
from their own resources [1]
 It would also reduce the possible need to raise debt finance and so reduce the
problems associated with gearing at this early stage [1]
 Opening up shareholdings could make it more difficult to manage staff in the medium
term. For example, it could prove more difficult to make an employee redundant if
that person is also a shareholder [1]
 The staff might also be unwilling to move on if they are unhappy because they could
feel tied to the company because of their investment [1]
 They may also feel entitled to greater latitude in their performance and in their
behaviour because they own some shares [1]
[7, Max 6]
[Total 20]
This question was answered very well. There were many good passes and many
candidates gave very good answers. The candidates in general showed a good
understanding of management buyouts and gave in depth answers which demonstrated an
understanding of the topic.
CB1 A2020
Q20
(i)
 Accounting performance ratios are generally calculated using book values and that is
an important enough reason to make the book value of equity relevant [1]
 The figure will only change from year to year in the event that Vonder seeks a fresh
injection of share capital or has a significant inflow from retained earnings [1]
 That makes the resulting ROCE ratio consistent from one year to the next, with
changes in capital employed only reflecting increases or decreases because of
investments or withdrawals [1]
 The book value of share capital also reflects the actual cash invested in the company
by the shareholders and so it is a realistic measure of the management team’s
performance [1]
 Basing ROCE on the market value of equity reflects the wealth created for the
shareholders in relation to the opportunity cost of leaving their investment with the
company [1]
 That makes it a more realistic measure of the benefits of investing in the company
from the shareholders’ perspective [1]
 It also holds the directors responsible for the value of the resources that have been
entrusted to them and the associated return that they earn from those resources [1]
 That could make life difficult for the directors because any increase in the share price,
which could be due their sound management of the business, will decrease their
ROCE [1]
 Having said that, it could also motivate the board to ensure that the shareholders are
adequately compensated for the investment that they are making [1]
[9, Max 8]
(ii)
 The investment in the factory will understate ROCE for the year ended 30 June 2020
[1]
 The capital employed will be inflated by $150 billion, despite the fact that the funds
were not invested in any meaningful way until a month before the year end [1]
 The operating profit does not appear to have increased by much in response to this
investment, if at all [1]
 There could have been additional costs that actually reduced operating profit for the
year because they could not be carried forward. For example, the costs of recruiting
staff to work in the factory will have been incurred and written off as a cost [1]
 The company could also have charged a month’s depreciation on the building [1]
 It would be far more realistic to base ROCE on an amount that excludes the fresh
investment. In other words 362 + 350 - 150 = $562 billion [1]
 Doing that would enable the shareholders to compare the ROCE of 48/562 = 9% with
the previous figure of 44/(351+240) = 7% [1]
 The alternative would be 48/(362+350) = 7% [1]
[8, Max 7]
(iii)
 In theory, if the shareholders are disappointed with the profitability and performance
of the company then the share price could decline [1]. ROCE reflects the company’s
ability to generate wealth from the resources that it has available to it and so it is a key
ratio for investors [1]
CB1 A2020
 That would, however, be a potentially naïve assumption which would depend on all
shareholders and potential shareholders being misled [1]
 In the short term, the announcement of misleading information could lead to
offsetting market forces, with the shareholders who are disappointed seeking to sell
pushing the share price down and those who believe that the news is not actually a
problem buying shares and pushing the share price up [1]
 There could be a brief period of turbulence, but that would not necessarily cause any
serious problems in the longer term because the market will be driven by informed
decisions by intelligent participants [1]
 The only real concern would be that the threat of such misunderstandings could lead
to the directors indulging in dysfunctional behaviour, such as not making investments
in case the market misunderstands them [1]
[5]
[Total 20]
[Paper Total 100]
Q20 was done badly. There were many weak answers to all parts of this question.
Candidates did not understand ROCE and could write very little for any parts of the
question. This question was the poorest in terms of numbers of passing candidates.
CB1 A2020
EXAMINATION
01 October 2020 (am)

Core Principles
If you encounter any issues during the examination please contact the Examination Team on
T. 0044 (0) 1865 268 873.

1 Which of the following best summarises the attitude that the directors of a quoted
company should take towards social responsibility?
A Social responsibility can and should constrain the creation of wealth.

B Social responsibility is just as important as the maximisation of shareholder
wealth.
C The directors should place social responsibility before their own interests.
D The directors should take care to ensure that they are seen to be socially
responsible, even if they are not.
[2]
2 How should the directors of a quoted company view agency problems?
A Agency problems are inevitable and so they should be ignored.

B Agency problems are perceived, but do not exist in reality.
C Agency problems concern the shareholders and not the directors.
D Agency problems may be reduced through transparency and accountability.
[2]
3 In many countries, capital gains are not taxed until the assets on which the gain
has arisen are sold. Which of the following is the most logical explanation of this
practice?
A It assists taxpayers in their tax planning.

B It ensures the maximum possible revenue into government funds.
C It is easier to determine an objective tax expense.
D It is unfair to tax capital gains.
[2]
4 Which of the following best explains why many countries do not allow depreciation to
be treated as an expense for tax purposes?
A Depreciation is not a real expense.

B The calculation of depreciation allows too much discretion.
C The tax treatment of depreciation maximises the revenue from corporate tax.
D There is no relationship between depreciation and cash flows.
[2]
5 Why might a manufacturing company’s return on capital employed be overstated

during times of inflation?
A Competitors will increase selling prices.

B Depreciation on property, plant and equipment may be understated.
C Employee wages will decline in spending power.
D Sales revenue will be overstated.
[2]
CB1 S2020–2
6 A wholesaling company has “prebooked” sales by recording revenues that will not be
earned until the first month of the following financial year. Which of the following
statements best describes the impact that this will have on the analysis of the
company’s financial statements for this year?
A Both sales and cost of sales will be overstated, so the accounting ratios will not
be affected.
B Inventory will be understated and trade receivables overstated.
C Profit and cash will be overstated.
D Profit will be overstated, but return on capital employed will be unaffected.
[2]
7 An insurance company’s financial statements show a conservatively high valuation of

liabilities in respect of insured risks. Which of the following best explains this?
A The directors wish to manipulate future profits.

B The external auditor has been negligent.
C The directors wish to manipulate the company’s tax bill.
D The nature of the industry makes such a valuation prudent.
[2]
8 You are reviewing the financial statements of several major retailers. One company
has a relatively high asset utilisation ratio and a relatively low profit margin. How
should this be interpreted?
A The company has a relatively high return on capital employed.

B The company has a relatively low return on capital employed.
C The company sets high prices in order to maximise profit.
D The company sets low prices in order to increase sales volume.
[2]
9 What is implied by a beta of zero on a potential investment?
A The investment is high risk.

B The investment is risk free.
C The investment will make a diversified portfolio less sensitive to movements
on the market.
D The investment will make a diversified portfolio more sensitive to movements
on the market.
[2]

10 In times of inflation:
A both real and nominal rates required from projects will be increased.
B both real and nominal rates required from projects will be unaffected.
C real rates required from projects will be increased, but nominal rates will be
unaffected.
D real rates required from projects will be unaffected, but nominal rates will be
increased.
[2]
11 Describe how guidance such as that contained in the UK Corporate Governance Code
might reduce concerns arising from agency theory. [5]
12 Describe how a company might determine whether it has the necessary “significant
influence” required to classify another company as an associate. [5]
13 A company has traditionally evaluated projects on the basis of their net present value
(NPV).
Discuss the advantages of extending project evaluation to include strategic fit as an

additional factor in investment appraisal. [5]
14 A commercial bank recently rejected a loan application from a large company. The
loan would have been secured by a specific charge against property that was worth at
least twice the amount borrowed, but the bank rejected the application on the grounds
that the risk of default on the loan was too high.
Discuss the bank’s decision to reject the loan application in these circumstances. [5]
15 A quoted company bases investment decisions on the internal rates of return (IRR)
offered by potential projects. In order to be accepted, a project’s IRR must be greater
than 12% per annum.
Discuss this investment criterion. [5]
CB1 S2020–4
16 Discuss the proposition that the cost of equity is zero for an unquoted company
because there is no observable share price. [5]
17 Discuss the proposition that the needs of all users of financial statements can be
satisfied by a single set of financial statements. [5]
18 Explain the relevance of a qualified audit opinion in which the external audit report
stated that the financial statements gave a true and fair view, except for a specified
disagreement over an accounting choice made by the company’s board. [5]

19 The information provided below was obtained from Dosco plc’s bookkeeping records
on 31 March 2020.
(i) Prepare Dosco plc’s financial statements in a form suitable for publication:
• statement of profit or loss [9]

• statement of changes in equity [2]
• statement of financial position. [4]
(ii) Discuss the implications of the loss on revaluation of property for Dosco’s
shareholders. [5]
[Total 20]
Dosco plc
List of balances as at 31 March 2020
$000
Administrative expenses 939
Cash at bank 155
Borrowings (long term) 361
Directors’ remuneration 1,366
Dividends paid 101
Interest on borrowings 44
Manufacturing materials – inventory at start of year 614
Manufacturing purchases 4,003
Plant and equipment – accumulated depreciation 939
Revenue 16,927
Sales salaries 890
Selling expenses 888
Share capital 1,626
Share premium 434
Trade payables 184
(1) Inventory was counted at 31 March 2020 and was valued at $740,000.
(2) Manufacturing costs exclude $50,000 of compensation that will be paid in

June 2020 to employees who were injured in an industrial accident.
(3) Property was valued at $1,500,000 on 31 March 2020. That valuation is to be

incorporated into the financial statements.
(4) Corporation tax of $1,337,000 is to be provided for the year.
CB1 S2020–6
20 Pantro manufactures laptop computers. The company was established 20 years
ago and has always had its factory in its home country. Pantro exports its products
worldwide.
Pantro’s directors are considering relocating production to a developing country that

has suitable infrastructure, including excellent transport links, but much lower labour
costs than the company’s home country. The potential host country’s government is
prepared to offer generous grants and tax incentives to encourage Pantro to relocate.
Much of Pantro’s production is mechanised, although the final assembly and packing
of laptops is labour-intensive.
(i) Identify the two most significant risks arising from the relocation of
production, giving reasons for their selection and recommending a suitable
mitigation for each. [10]
(ii) Suggest the two most significant problems that will arise in budgeting
for labour costs at the new factory, giving reasons for their selection and
recommending a response to each. [10]
[Total 20]
END OF PAPER
CB1 S2020–7
EXAMINERS’ REPORT
September 2020

Core Principles
Introduction
Mike Hammer
December 2020

Subject CB1 (Business Finance – Core Principles ) – September 2020 – Examiners’ report

institutions.

methods, taxation, basic management accounting, net present value and project
appraisal and other topics, it has both calculations and essay type questions on
these topics. The paper also examines financial reporting including preparation of
the main financial statements and interpretation of financial statements. It also
considers the basis of the preparation of statements and the information needs of a
variety of end users of financial statements.

working is shown.
B. Comments on candidates’ performance in this diet of the examination.

Many candidates performed very well in this exam. The Multiple Choice
Questions (MCQs) were done reasonably well. The short response questions were
reasonable, some were answered very well and others, usually where application
was required, were answered not that well. Performance in Question 19 was very
good with many candidates scoring a high mark, the question was on preparing
financial statements. Performance in Question 20 was a little weaker than 19. The
question was divided into two parts, part i on risk was done quite well but part ii
was on budgeting for labour for a new venture overseas and was done not that
well by most candidates.
The area in which candidates’ performance was the weakest was finance, this is
often the case with this exam.
Candidates were good at questions which mainly tested knowledge but were a
little weak on application of knowledge to scenarios.
Having said that, the results were in line with previous diets and many candidates
performed very well.
C. Pass Mark
The Pass Mark CB1 was 58.
1037 presented themselves and 634 passed.
CB1 S2020 ©Institute and Faculty of Actuaries

Solutions for Subject CB1 September 2020
Q1 A [2]
Q2 D [2]
Q3 C [2]
Q4 B [2]
Q5 B [2]
Q6 B [2]
Q7 D [2]
Q8 D [2]
Q9 C [2]
Q10 D [2]
Questions 1-10 were generally well answered by candidates. Many candidates achieved a
high mark.
Q11
Codified statements demonstrate the commitment of regulators to addressing governance
Issues [1]
Stakeholders should be reassured that agency problems have been identified as a problem and
will be dealt with through regulation [1]
Setting the standard requires a public debate about the extent to which rules should be
imposed. Interested parties can contribute to that debate [1]
The statements also provide an easily understood benchmark against which the quality of
governance can be measured. If a company claims to be compliant then that claim can be
verified [1]
Codified statements set a minimum acceptable standard for behaviour, or require companies
to explain explicitly to shareholders why they are taking a different approach.
[1]
Stakeholders can be reassured that the directors are sufficiently committed to sound
governance to meet, or even exceed, the codified rules [1]
Codified guides can address common areas where agency problems might arise, such as
directors taking excessive remuneration. [1]
[Marks available 7, maximum 5]
This question was generally well answered by many candidates. Some discussed the
governance guidance in detail which was awarded marks. The main problem with some
weaker answers was candidates quoting the governance guidance and not really
answering the question.
Q12
Significant influence can be difficult to identify because, by definition, it is less definite than
control [1]

If an entity is under the control of another then it is a subsidiary [1]

Significant influence implies more than simply having the right to vote at general meetings,
because that relationship would imply a simple investment [1]
In general, significant influence is implied by ownership of between 20% and 50% of
equity [1]
That is not, however, sufficient in itself to determine significant influence. The shareholder
must also be able to demonstrate that it has some influence over strategic decisions [1]
One way to do that would be to have the right to appoint a director, who can speak during
board meetings and can vote, but who does not have outright control [1]
This question was asnwered badly by most candidates. Candidates could not discuss
significant influence in any depth and tended to discuss subsidiaries and consolidations in
general terms and did not really answer what was asked.
Q13
The biggest advantage of adding strategic fit would be that the company would be more open
to projects that could have the potential to increase wealth, even if that cannot be
demonstrated through NPV calculations [1]
For example, a potential investment could have a negative NPV, but it could also create
scope for the entity to exploit potential opportunities that might arise in the future [1]
One example might be the acquisition of a supplier of an important material. If that material
becomes scarce in the future then the company will have a guaranteed supply [1]
Strategic fit would also help with capital rationing decisions [1]
If the company cannot afford to finance all of the positive NPV projects that are available to
it then it might make sense to focus on those that might offer synergies that can have a wider
value across the entity [1]
It will also make it more difficult for managers to seek investments that are intended to use
up capital investment budgets if they have to show that there is a strategic value beyond
NPV [1]
This question was answered very well by many candidates. Candidates demonstrated a
good knowledge of NPV and understood that sometimes strategic fit could also be taken
into account when assessing projects.
Q14
The specific security against the property means that the bank would not be subject to any
risk of the loss of principal [1]
In that case, it could be argued that it would be short-sighted to turn down the lending
opportunity [1]

Having said that, the bank would not wish to be responsible for the foreclosure of a loan that
could put a customer out of business [1]
Doing so would create the impression that the bank is greedy and uncaring [1]
The availability of security cannot ever be the only consideration. Apart from anything else,
if the customer could not be expected to make all payments on time there will be costs
associated with managing the account [1]
Payments will have to be chased and negotiated [1]
The foreclosure itself would also leave the bank holding the asset pledged as security and
having to find a buyer [1]
There is also a risk that the property will decline in value, leaving the bank with insufficient
to recover its loss [1]
[Marks avalabile 8, maximum 5]
This question was not answered as well as other questions. Candidates did not have many
ideas as to what would put a lender off lending to a business.
Q15
The first thing is that IRR does make allowance for the time value of money, which is a key
consideration in terms of linking the investment decision to shareholder wealth [1]
IRR is a valid basis for accepting or rejecting projects provided it can be established that the
IRR is greater than the cost of capital [1]
IRR is not, however, an ideal basis for choosing between mutually exclusive projects [1]
A project with a higher IRR could be limited by a short life or a low initial investment and so
it may not be the one to maximise shareholder wealth [1]
Setting a fixed IRR target of 12% ignores the possibility that different projects have different
risk characteristics [1]
It is possible that 12% is too low a target for some projects and too high for others [1]
That could be taken into account by considering qualitative issues associated with risks and
non-financial criteria such as strategic fit [1]
This question was one of the questions which was answered not very well. Candidates found it
difficult to write much for this question. Candidates often moved on to discuss NPV which was
not required.
Q16
The company’s shares will have a value that will be affected by the returns on offer to the
shareholders, regardless of whether the shares are quoted or not [1]
The directors must offer the shareholders an adequate return on their shares, otherwise the
shareholders will respond adversely [1]
For example, the shareholders may be more open to offers to buy a controlling interest in the
event that the company offers a poor return [1]

With quoted companies, an inadequate rate of return will lead to a decline in the share price
so that the market obtains the rate that it deems appropriate. With unquoted companies, the
shareholders may have to take slightly more extreme measures. For example, they may
penalise the directors for failing to offer an adequate return [1]
They may vote against salary increases or may even vote directors out of office [1]
Overall, the required rate of return is implicit in every company’s equity finance but it is
more difficult to observe it directly in the case of an unquoted company [1]
This question was answered badly by many candidates but very well by others. There were
some reasonable marks for this question as well as some very low marks. Candidates
wrote very short answers which tended to discuss quoted companies rather than small
unquoted companies.
Q17
Different users are interested in different matters relating to the company. For example,
lenders are primarily interested in the security of their loans and so they need to have a clear
understanding of the financial position and the cash flows [1]
Shareholders are in a slightly different position, being interested primarily in profitability and
the ability to pay dividends [1]
The differences between users may be open to exaggeration. For example, the shareholders
are likely to be interested in most of the issues that concern the lenders, even if some of those
issues are less important to them [1]
A set of financial statements that was drafted with the shareholders in mind would probably
offer sufficient information to meet the lenders’ needs too [1]
Many users are also in a position to interact with the company and to supplement the
information that is published [1]
For example, lenders can make the provision of specific information a condition of advancing
a loan, so they will not be affected by setting accounting requirements that are primarily
directed at other users’ needs [1]
This question was answer quite well by many candidates. Most candidates could discuss
the needs of users of financial statements well.
Q18
In itself, this form of audit report suggests that the users of the financial statements, primarily
the shareholders, must decide between two figures [1]
The qualified report will state the nature of the auditor’s disagreement and will quantify its
effects on profit and financial position [1]
Financial reporting is a professional activity that involves subjective judgement and so there
is never a single “correct” set of figures, but the fact that the auditor has offered an alternative
to the directors’ estimates suggests that users should take care in reading the financial
statements [1]

It is unusual for auditors to find it necessary to disagree because they usually resolve any
differences privately through negotiation with the directors [1]
The fact that such an agreement could not be reached suggests that there could be concerns
about the directors’ motivation [1]
For example, the company might have been forced to distort its statement of financial
position in order to avoid breach of a debt covenant [1]
This question was not answered very well with candidates discussing auditing and audit
reports in general rather than the specifics of the question. Many candidates wrote enough
to pass but did not achieve a high mark.
Q19 (i)
Dosco plc
Statement of Profit or Loss
$000
Revenue 16,927 [½]
Gross profit 9,938
Finance costs (44) [½]
Income Tax Expense (1,337) [½]
[1]
Dosco plc
Statement of Changes in
Equity
Share Share Retained
capital premium Earnings Total
£000 £000 £000 £000
Opening balance 1,626 434 1,610 3,670 [½]
Profit for the year 4,474 4,474 [½]
Dividends (101) (101) [½]
Closing balance 1,626 434 5,983 8,043
[½]

Dosco plc
as at 31 March 2020
Notes $000
Non-current assets
Property, plant and equipment [1] 7,642
Current Assets
Inventory 740 [½]
Trade receivables 1,438 [½]
Cash at bank 155 [½]
2,333
Total assets 9,975

Equity
Share premium account 434
Total equity 8,043
Borrowings 361 [½]
Current liabilities
Trade payables 184 [½]
Provision for compensation 50 [½]
Tax 1,337 [½]
1,571

[1]

Notes
1. Property, plant and

equipment
Plant and
$000 $000 $000
Cost or valuation
At 31 March 2020 1,500 7,081 8,581 [½]
Depreciation
At 31 March 2020 - 939 939 [½]
Net book value
At 31 March 2020 1,500 6,142 7,642
Workings
Cost of sales
Manufacturing costs 1,734 [½]
Opening inventory 614 [½]
Purchases 4,003 [½]
Wages 1,120 [½]
Closing inventory (740) [½]

Compensation 50 [1]
Loss on revaluation 208 [1]
6,989
Property - cost 3,251
Property - depreciation (1,543)

1,708
Valuation 1,500
Loss on valuation 208
Distribution
Sales salaries 890 [½]
Selling expenses 888 [½]
1,778

Expenses 939 [½]
Directors' remuneration 1,366 [½]
2,305
[Total 15]
(ii)
The loss on revaluation reflects a decrease in the fair value of the property. That suggests that
its market value has decreased [1]
It could be argued that this means very little to the shareholders if the company does not
intend to sell the property because it will still retain its ability to generate future cash flows
for Dosco [1]
The only immediate concern is that the decrease will reduce the collateral that is available to
potential lenders and so Dosco’s borrowing capacity may be diminished [1]
The recognition of the loss on revaluation as an expense could confuse the readers of the
financial statements [1]
The profit for the year has diminished in order to complete the bookkeeping entries for the
loss on valuation, even though that loss does not necessarily reflect Dosco’s trading
activities [1]
While the loss will reduce this year’s profits, it will have the effect of reducing depreciation
in future years and so reported profit will increase. That could have the effect of making the
shareholders believe that performance has improved [1]
The loss will also reduce equity, which will increase the gearing ratio, even though the cost of
servicing existing debts will not be any more onerous [1]
[Total marks available 7, maximum 5]
Part i of this question was answered very well by most candidates.

Part ii was done less well and sometimes missed out all together. Usually answers were
too brief.
Q20 (i)
There may be adverse social and political consequences to this move [1]
Pantro will be making its workforce redundant and the company will be viewed as severing a
significant tie to its home country [1]
That could lead to a decrease in future revenues if buyers feel the need to buy their laptops
from an alternative supplier [1]
Pantro might mitigate that risk by focussing on the need to remain competitive, given that
laptops are essentially a commodity product and the market is price sensitive [1]
The fact that the company will remain headquartered in its home country means that it will be
contributing to its home economy through paying tax [1]
It will also be providing employment opportunities in a developing country where
opportunities might otherwise be scarce [1]
There could be concerns about product quality, arising from the fact that a new workforce is
being employed in a newly established factory [1]

That could be due in part to the learning curve in the early stages of production and also to a
lack of staff commitment to the company in the early stages [1]
If Pantro develops a reputation for poor quality then it could lose a great deal of goodwill and
its sales volumes could take a very long time to recover [1]
This risk could be avoided by building up a stockpile of laptops to cover the period
immediately after the transition to the new factory [1]
The new production process could then be subject to the highest possible scrutiny, with
extensive testing of all output [1]
If necessary, sub-standard machines could then be rectified or even scrapped, with feedback
to the production staff [1]
(ii)
The most immediate problem may be in establishing the number of employees who will
actually be required [1]
If they lack the necessary skills to operate at the rates that their predecessors from the home
country achieved then Pantro may require more employees than they had before [1]
There may also be a high staff turnover because other employers may be coming into the
country and offering better rates of pay or terms and conditions and that could require
additional appointments to act as a buffer [1]
The most immediate response to this would be to develop aptitude tests for potential
appointees to ensure that they can master the assembly tasks [1]
Pantro should monitor the markets carefully and should ensure that it matches the rates and
working conditions that are offered by competitors for staff [1]
Minimising staff losses through avoiding dismissal and resignation will give Pantro a clearer
basis for planning and budgeting staff numbers [1]
The hourly rates paid to staff could be difficult to predict because of changes in the local
economy [1]
An influx of new employers, attracted by the government incentives, could create an
unhealthy competition for new starts, forcing up rates [1]
The potential to save employment costs could be undermined, as has happened with many
developing countries in the past [1]
Pantro could start with its own economic forecasts concerning basics such as rates of
unemployment, cost of living, etc [1]
If the host country has large numbers of potential employees so that there is little immediate
prospect of full employment then hourly rates will be easier to predict with some
certainty [1]
If the local economy is likely to see rising living costs because of, say, housing shortages then
rates of pay will almost certainly increase because of a rising cost of living [1]
In part i marks were awarded whatever two risks were discussed as long as they were
reasonable. Candidates did well in this part of the question.
Candidates did not answered very well part ii of this question. Marks were fairly low for
this question. Candidates failed to link the idea of budgets and labour costs convincingly.
This question required application not just knowledge and candidates always find that
difficult.


EXAMINATION
21 April 2021 (am)

Core Principles

1 Why are quoted companies required to have non-executive directors on their boards?
A Executive directors are corrupt and incompetent.

B Executive directors are often inexperienced.
C Non-executive directors can fulfil a supervisory role.
D Non-executive directors require lower salaries than executives.
[2]
2 Which of the following is an agency cost?
A Board meetings
B Directors’ salaries
C External audit of a company’s financial statements
D Interest on corporate debt.
[2]
3 A parent company has a foreign subsidiary located in a host country that does not
have a double tax arrangement with the parent’s home country. The foreign subsidiary
pays regular dividends to the parent company. Which of the following will apply?
A The subsidiary will not be taxed on profits earned in its host country and the
parent will pay tax on dividends in its home country.
B The subsidiary will pay tax on profits earned in its host country and the parent
will not be required to declare the dividends as taxable income in its home
country.
C The subsidiary will pay tax on profits earned in its host country and the parent
will pay tax on dividends received in its home country.
D The subsidiary will pay tax on profits earned in its host country and the parent
will pay tax on dividends received in the subsidiary’s host country.
[2]
4 A company has issued subordinated debt securities. Which of the following reflects
the priority that would apply in the event of default?
A Mortgage loans first, followed by preference shares, then equity shares, then
subordinated debt.
B Mortgage loans first, followed by preference shares, then subordinated debt,
then equity shares.
C Mortgage loans first, followed by subordinated debt, then preference shares,
then equity shares.
D Subordinated debt first, followed by mortgage loans, then preference shares,
then equity shares.
[2]
CB1 A2021–2
5 A company with floating rate debt has entered into a swap arrangement with a
counterparty that has fixed rate debt.
What are the implications to the company of a default by the counterparty?
A Nothing will change.

B The company will be forced to pay interest on both loans.
C The company will be left with floating rate debt.
D The company’s loan will be written off.
[2]
6 A holiday company takes bookings for holidays up to a year before customers travel.
The company recognises revenue from those bookings in the same accounting period
as the costs associated with providing the holidays is incurred.
Which accounting concept is the holiday company applying?
A Accruals
B Dual aspect
C Matching
D Prudence.
[2]
7 Why do analysts disregard intangible assets when calculating net asset value per
share?
A Intangible assets have no value to the shareholders.

B Intangible assets may prove difficult to sell if the company fails.
C It is unrealistic to expect company directors to use intangible assets to create
value.
D Only tangible assets can be controlled.
[2]
8 Which of the following is a valid formula for Return on Capital Employed (ROCE)?
D
[2]
CB1 A2021–3
9 A company’s factory cost $50 million. Depreciation to date on the building is $12
million. The factory was recently valued at $55 million. What amount will appear in
the company’s revaluation reserve in respect of this revaluation?
A $5 million
B $17 million
C $38 million
D $55 million.
[2]
10 J is a quoted company that owns 5% of K, an unquoted company. J has contracts in

place that gives it the right to be involved in any decisions made by K’s directors. J
also has the right to replace K’s directors at any time. How should K be accounted for
in the J Group’s consolidated financial statements?
A As an associate
B As an investment
C As a non-controlling interest
D As a subsidiary.
[2]
11 Directors are duty-bound to maximise shareholder wealth.
Discuss the impact on this duty if they must also consider the needs of a wider range
of stakeholders. [5]
12 Describe the difficulties in deciding whether a particular quoted company is a suitable

acquisition target for a larger quoted company. [5]
13 A change in safety regulations will require a train company to fit new equipment to all
trains. The company does not believe that the equipment will reduce the risk of
accidents and it will be expensive.
Explain the usefulness of the Net Present Value (NPV) criterion in planning the
company’s response to this change. [5]
14 A quoted company has a policy of seeking an internal rate of return of at least

14% p.a. on all investments of more than €5 million. This rate was set 5 years ago.
Describe the company’s approach to capital project appraisal. [5]
CB1 A2021–4
15 A quoted company’s directors have drafted their financial statements in a manner that
they claim is realistic, despite the fact that it does not comply with International
Financial Reporting Standards (IFRS). Changing the figures to comply with IFRS
would lead to the recognition of a loss instead of the profit shown in the draft
statements.
Explain how the company’s external auditor would respond to this. [5]
16 Describe the purpose of integrated reporting. [5]
17 An actuarial consultancy invoices its clients on a monthly basis, based on the time
spent on each client. The consultancy has four major clients who often take as long as
3 months to settle any given invoice.
Explain the implications of slow payment by these clients for the consultancy. [5]
18 An actuarial consultancy has a budgetary system in place to monitor costs and

revenues. During the year ended 31 March 2021, hours charged to clients exceeded
the budget by 8%. Profit was 3% over budget, after taking account of adverse
variances on staff overtime and on office heat and light. The consultancy’s Board is
considering reducing the office manager’s bonus because of the two adverse
variances.
Describe the implications of holding the office manager responsible for the adverse
variances under these circumstances. [5]
CB1 A2021–5
19 The information provided below was obtained from Hopplo plc’s financial statements
for the year ended 31 March 2021.
(i) Calculate the following ratios for the two accounting years:
(a) Return on Capital Employed (ROCE) [2]
(b) Gross profit percentage [2]
(c) Distribution costs as a percentage of revenue. [2]
(ii) Assess Hopplo’s performance for the year ended 31 March 2021. [9]
(iii) Discuss the difficulties in assessing Hopplo’s performance on the basis of the
information provided. [5]
[Total 20]
Hopplo plc
Statement of Profit or Loss

for the year ended 31 March
2021 2020
$000 $000
Revenue 22,427 19,502
Cost of sales (7,177) (7,411)
Gross profit 15,250 12,091
Distribution costs (2,467) (1,365)
Administrative expenses (1,121) (1,170)
Operating profit 11,662 9,556
Finance costs (6,080) (3,360)
Profit before tax 5,582 6,196
Income tax expense (1,228) (1,363)
CB1 A2021–6
Hopplo plc
as at 31 March
2021 2020
$000 $000
ASSETS
Non-current assets
Current Assets
Inventory 658 680
Trade receivables 1,869 1,625
Cash at bank 43 340
2,570 2,645
Total assets 183,570 148,645

Equity
Called-up share capital 70,000 70,000
Share premium account 20,000 20,000
Total equity 105,792 104,706
Borrowings 76,000 42,000
Current liabilities
Tax 1,180 1,321
1,778 1,939
Total of equity and liabilities 183,570 148,645
CB1 A2021–7
20 Drentel is a quoted company that manufactures bicycles and was established many
years ago. It has been making losses for the past 5 years because its products have not
kept up with consumer tastes and sales have been declining.
Despite the losses, Drentel has continued to pay a steady dividend each year.
Drentel’s Board is considering a proposal to sell a range of battery-powered electric

bicycles, which is a major growth area in the bicycle market. Drentel’s current range
of bicycles is suitable for modification to carry an electric motor. This would require a
significant investment in order to acquire the rights to use patented manufacturing
processes and also to acquire the specialised machinery that would have to be built to
Drentel’s specifications. The investment required is equivalent to approximately 25%
of the company’s market capitalisation.
Drentel’s beta is currently 1.8. The Board believes that the beta will fall to 1.6 if the
company proceeds with the electric bicycle project.
(i) Evaluate the relevance of the decline in Drentel’s beta for the decision to
invest in electric bicycles. [10]
(ii) Discuss Drentel’s policy of maintaining its dividend payments despite losses.
[10]
[Total 20]
END OF PAPER
CB1 A2021–8
EXAMINERS’ REPORT
April 2021
Subject CB1 - Business Finance

Core Principles
Introduction
Paul Nicholas
July 2021

CB1 - Business Finance - Core Principles - April 2021 - Examiners’ report
1. The aim of the Business Finance subject is to provide a basic understanding of corporate
finance including a knowledge of the instruments used by companies to raise finance and
manage financial risk and to provide the ability to interpret the accounts and financial
statements of companies and financial institutions.
taxation, net present value and project appraisal and other topics. It has both calculations
statements. It also considers the basis of the preparation of statements and the information
needs of a variety of end users of financial statements. There is now some management
accounting in the syllabus so there are questions on topics such as budgeting and
performance management.
3. Different numerical answers may be obtained to those shown in these solutions depending
on whether figures obtained from tables or from calculators are used in the calculations
but candidates are not penalised for this. However, candidates may lose marks where
excessive rounding has been used or where insufficient working is shown.
B. Comments on candidate performance in this diet of the examination.
1. Performance was good for many candidates. Many of the questions were answered
very well. The MCQ were answered very well with high marks being achieved by
many candidates. Some of the short questions were answered well but others were
answered poorly. There were two questions where poor performance was most
noticeable, question 20 part (i) and question 12.
C. Pass Mark
1,213 presented themselves and 744 passed.

Q1 C [2]
Q2 C [2]
Q3 C [2]
Q4 C [2]
Q5 C [2]
Q6 C [2]
Q7 B [2]
Q8 C [2]
Q9 B [2]
A = 55 - 50
B = 55 - (50 - 12)
C = 50 - 12
D = 55
Q10 D [2]
Performance was very good in the MCQ; many candidates scored more than 16 marks
which was excellent.
Q11
Directors’ primary duty is to the shareholders, specifically the maximisation of shareholder
wealth [1]
That is a suitable duty because it can be readily understood and easily communicated to
stakeholders [1]
It also enables the shareholders to be confident that their wealth is being managed in a
manner that is to their financial advantage [1]
It is, however, accepted that companies should also be managed in a manner that meets the
needs of a wider range of stakeholders, including employees and society [1]
Those duties need not prevent the maximisation of wealth because they can be discharged by
complying with the spirit of rules and laws and taking account of reputational matters. It is
not, for example, in the shareholders’ interests to profit from lax health and safety that reduce
short-term costs [1]
Performance was very good in this question with a number of candidates scoring full
marks.
Q12
The biggest difficulty is that the buyer may be unable to obtain any detailed information,
beyond that which is available in the public domain [1]
The directors of the target company may be unwilling to encourage potential buyers because
their jobs and, indeed, their careers may be put at risk and so may be reluctant to provide
them with advice or support [1]
Takeovers are often motivated by the prospect of synergies between the buyer and the target,
but those can be difficult to realise [1]

Potential synergies identified before acquisition may disappear because of issues such as the
loss of expertise if the target company’s staff are unhappy and choose to resign rather than
remain with the company [1]
A further concern is that the predator’s shareholders may not understand the business case for
the takeover and so the share price might fall in the aftermath of the announcement that the
takeover is planned [1]
This question was one of the least well answered. Many candidates discussed how
goodwill was calculated which was not required and others discussed how a
subsidiary could be shown in the financial statements which was again not required.
Q13
It seems likely that the investment in the new equipment will reduce the train company’s
market capitalisation because it involves an outflow with no positive result in the form of
additional future inflows [1]
In that sense, the investment fails the NPV criterion because it appears to be a negative NPV
investment and so it should not be selected [1]
If challenged, the board could argue that the need to comply with the safety regulations
means that the revenues from the sale of tickets will become a relevant cash flow in terms of
the decision to proceed [1]
Once the regulations come into effect, the company would be forced to take its trains out of
service unless the equipment has been fitted, which almost certainly makes this a positive
NPV investment [1]
The NPV criterion would suggest that the implementation of the investment should minimise
the present value of the cash outflow. The company should delay the investment for as long
as possible, ideally allowing the modifications to be scheduled to coincide with scheduled
maintenance and servicing [1]
This was reasonably answered, however, many candidates failed to discuss that the
company was forced to invest for health and safety reasons. Many candidates wrote
generic answers on NPV.
Q14
The 14% rate is not necessarily relevant to every investment opportunity. Ideally, the
company should set a rate that takes proper account of the cost of capital and the risks
associated with the investment [1]
Having said that, the 14% rate can be justified on the basis of the outcomes of projects that
have been accepted and rejected in the past. If the company has been accepting too many
projects, or projects that have failed then the policy is not working [1]
Setting specific rates for projects would still require subjective judgements that could be
viewed as invalid with the benefit of hindsight [1]
The 14% threshold requires the company to prepare a formal statement of relevant cash flows
in order to determine an IRR, which would require detailed consideration of the assumptions
underlying the decision [1]

The 14% criterion would be relatively easy to communicate to shareholders and other
stakeholders, who would be able to consider whether that seems like a realistic target for a
company in this industry [1]
Q15
The external auditor’s duty is to evaluate and report on whether the financial statements
present fairly, so that the shareholders can establish whether the financial statements can be
trusted for decision making purposes [1]
The auditor is expected to base the evaluation on professional judgement, but that judgement
will be informed by the company’s compliance with relevant accounting regulations,
including IFRS [1]
The stakeholders who will be relying on the auditor’s opinion are likely to take it for granted
that the financial statements comply with IFRS because those form a basis for determining
whether the statements give a fair presentation [1]
The auditor will undoubtedly attempt to persuade the directors to revise the draft financial
statements so that they comply with the rules [1]
If they are unable to do so then they will be required to issue a modified audit report that will
state that the financial statements present fairly “except for” the figures that are deemed to be
misstated because of the failure to comply with IFRS [1]
This question was answered reasonably well by many candidates.
Q16
Integrated reporting aims to provide stakeholders with a broader understanding than can be
obtained from traditional financial statements [1]
It supplements the usual accounting statements and notes with non-financial information that
deals with issues that will be of interest to shareholders and also to a wider range of
stakeholder [1]
For example, the statements will give an insight into the approach taken to risk management,
which will interest shareholders primarily because of the financial impacts but will also be
relevant to the employees and customers who may be the subject of some of those risks [1]
Integrated reporting encourages company boards to consider the wider social responsibilities
that all companies have [1]
Integrated reporting requires some consideration of environmental performance as well as
wealth creation. That enables the shareholders to be better informed about the overall impact
of their companies and enables shareholders to be satisfied that they are not profiting from
harm caused to people or the environment [1]

Q17
Slow payment by clients will disrupt cash flows and will reduce available cash. The
consultancy may have to bear additional overdraft fees and interest in order to finance its
investment in receivables [1]
Cash will have to be released from elsewhere in order to ensure that the consultancy can meet
its own commitments, which may divert funds from activities that would otherwise generate
profits [1]
Managing cash flows will distract management from the business issues associated with
running the consultancy [1]
The slow payments will also require the consultancy to waste time and effort in chasing
clients for payment [1]
Clients may decide not to make payment until they are forced to pay, so that they can benefit
from retaining cash within their own businesses [1]
This question was done reasonably well with many candidates discussing the
detrimental effects on cash flow in detail.
Q18
The issue here is that the consultancy has exceeded budgeted activity by charging more
billable hours than had been budgeted, which has also led to additional profit [1]
While those variances are to be welcomed, it appears that there have been corresponding
adverse variances in the form of overtime payments and office running costs. The manager is
likely to be very demotivated if those additional costs are regarded as inefficiencies because
the company would not have earned the extra profit without them [1]
There could be an argument that the costs should have been flexed to take account of the
additional (and welcome) activity [1]
There could be a counter-argument that the adverse variances should be at least investigated
to ensure that they were unavoidable in the context of the additional billings [1]
If adverse variances are simply disregarded then the danger is that the budgets will no longer
be viewed as the basis for spending decisions [1]
This question was answered badly. This is a fairly new topic for CB1.
Q19
(i)
2021 2020
ROCE 11,662/(105,792+76,000)= 6% 9,556/(104,706+42,000)= 7% [2]
Alternatively:
5,582/105,792= 5% 6,196/104,706= 6%
GP% 15,250/22,427 = 68% 12,091/19,502 = 62% [2]
Dist/revenue 2,467/22,427= 11% 1,365/19,502= 7% [2]

(ii)
The most important point is that the company’s ROCE declined slightly from last year,
admittedly, by only one percentage point [1]
That suggests that the directors have earned a poorer return in the resources that were made
available to them, which is a significant concern with regard to their performance [1]
Having said that, the company appears to be in a transition and so the results may require
further investigation before offering a final judgement [1]
The investment in property, plant and equipment increased significantly. Hopefully, that
investment is expected to generate further profits in the future and will lead to an increase in
ROCE [1]
In the short term, it may be that the investment in investment has depressed ROCE because
the assets have not had a full year in which to yield savings or generate revenues [1]
The ratios provided above could understate the overall performance of the company and its
board [1]
The company also appears to have modified the business model. Revenue has increase from
19,502 to 22,427, an increase of 15% [1]
That appears to coincide with an increase in distribution costs, both in absolute terms and as a
percentage of revenues [1]
The additional spend appears to have enabled the company to inflate its mark-up on sales [1]
(iii)
The financial statements do not indicate when the new assets were purchased. The
assumption is that they were acquired during the year, but they could have been purchased on
the first day of the financial year [1]
It would give a clearer indication of the capital employed if there was an indication of when
the assets were purchased and made fully operational [1]
There are no details of any changes to Hopplo’s business model [1]
If the company has changed the nature of the products that it makes and sells then the
increased gross profit % may be misleading. The increase could simply be due to the
company moving to a different market segment or even a totally new market [1]
There is no information about the industry, so we cannot obtain details about the performance
of similar businesses in the same industry for the sake of comparison [1]
[Total 20]
This question was answered reasonably well by many candidates, however, there were
also some weak answers especially in part (iii).
Q20
(i)
The beta reflects the sensitivity of returns on equity to changes in the return on the market as
a whole [1]
Generally, a lower beta equates to a lower risk for shareholders and so the decrease will be
welcomed and may lead to an increase in the share price [1]
The reduction suggests that the required rate of return on the electric bicycles is relatively
low compared to the rest of the business and so Drentel will find it easier to justify the
investment [1]
The reduction in beta suggests that the project is more likely to have a positive NPV [1]

The shareholders could, however, derive the same benefit from investing in any other
company that is investing in electric bicycles and Drentel’s Board need not necessarily invest
in this new product in order to create this benefit [1]
Beta measures risk from the perspective of the shareholders, whose investment is regarded as
a part of a diversified portfolio [1]
The decrease in beta does not mean that the project will be a low-risk investment for Drentel
itself because the company will be exposed to total risk [1]
That could leave stakeholders who cannot diversify, such as employees, exposed to the risk
of significant loss [1]
Total risk could be very high even if beta is low because a low beta simply means that the
returns on an asset are not well correlated with the returns on the market as a whole [1]
The directors could be taking a significant risk with their own careers if they make this
investment and it proves unsuccessful [1]
(ii)
If a company is making losses then dividends have to be funded from profits earned in
previous years [1]
Those retained earnings could be viewed as a long-term source of funding that was set aside
to finance future growth, but is now being used to finance dividend payments [1]
Paying dividends from retained earnings is not sustainable in the long term. It erodes the
funds available for investment [1]
It also implies that the directors have no strategies in place to put those funds to use in order
to address the losses [1]
The company will, eventually, run out of distributable reserves. More worryingly, it may run
out of cash before the distributable reserves have been exhausted [1]
The fact that the directors are maintaining the dividend could, however, be viewed as a signal
of confidence [1]
The fact that the ongoing payments can only be sustained if the company returns to profit
implies that they have an idea of how they are going to address the predicament that they find
themselves in [1]
The fact that this signal is costly because it could cost their reputations if they cause the
company’s collapse through such a strategy makes the signal all the more credible [1]
The existing shareholders may be willing to retain their shares, and so reduce downward
pressure on the share price, because they are willing to speculate on the continuing dividend
stream [1]
If the directors can, indeed, maintain those payments then the shares will have value for that
alone [1]
[Total 20]
In general part (i) was weak; this part was missed out by some candidates and many
did not achieve a high mark. Finance questions are often answered badly.
There was a general lack of understanding of beta.
Part (ii) was answered very well by most candidates.
[Paper Total 100]

EXAMINATION

Core Principles
Time allowed: Three hours and twenty minutes
If you encounter any issues during the examination please contact the Assessment Team on
T. 0044 (0) 1865 268 873.

1 Which of the following best explains a ‘comply or explain’ approach to codifying the
principles of sound corporate governance?
A Directors who do not comply will be fined.

B Market forces can encourage compliance.
C Stakeholders do not care about compliance.
D There is no agreement on the principles.
[2]
2 Which of the following would be a valid justification for paying the directors of a
quoted company a percentage of reported profits rather than fixed salaries?
A It would encourage better performance by the directors.

B It would encourage more accurate financial reporting.
C It would ensure that the directors are well paid.
D It would punish the directors for their mistakes.
[2]
3 Which of the following would be a suitable succession plan for the membership of a
quoted company’s board?
A A committee of non-executive directors should recruit replacement board

members.
B Non-executive directors should be promoted to vacant executive positions.
C Outgoing directors should recommend their successors.
D The Chief Executive should select a replacement.
[2]
4 A quoted company has had a policy of reinvesting profits in ongoing expansion and
has paid relatively small dividends. The company is now entering a phase where it no
longer requires funds for expansion. The directors therefore intend to start paying out
a larger proportion of profits as dividends.
Which of the following would be the most suitable approach to implementing this
new policy?
A Announce the policy change at the time of the next dividend announcement.
B Announce the policy change well before the next dividend announcement.
C Continue with the present dividend policy and allow cash to accumulate.
D Increase dividend payments without announcing a change in policy.
[2]
CB1 S2021–2
5 A private company was established 5 years ago. A family friend of the founder
contributed 10% of the initial equity. The company is now successful and solvent and
no longer needs the friend’s equity. The company's board has agreed that it will help
the friend to liquidate their investment.
Which of the following would be the most suitable means of assisting the family
friend?
A The company could pay a large dividend.

B The company could repurchase the shares from the friend.
C The company could seek a stock market quotation.
D The friend could sell their shares on the open market.
[2]
6 Jane has invented an innovative and exciting new device that will enable its wearers
to monitor their calorie intake more efficiently. She requires $200,000 to develop this
device into a marketable consumer product. To raise funds, she is considering a
crowdfunding arrangement in which potential buyers of the device will prepay for
their device in return for a 30% discount against the projected retail price.
Which of the following is an advantage of this arrangement to Jane?
A Jane is guaranteed the funding that she requires.

B Jane will receive free finance.
C There is no need to invest time and effort in raising finance.
D Traditional loans will be more complicated to arrange.
[2]
7 A quoted company has a significant loan secured against valuable land and buildings.
The company has been making losses for several years, but it is not yet in danger of
closure.
Which of the following best describes the reason for the company’s cost of debt being
high?
A The company cannot obtain tax relief on interest payments.

B The company cannot pay dividends.
C The lenders are likely to lose their principal.
D The lenders will request an increase in the rate of interest.
[2]
CB1 S2021–3
8 Which of the following best explains why the UK does not tax income from certain
types of investment, such as an Individual Savings Account (ISA)?
A Income from investments such as ISAs is difficult to measure and so tax.

B Returns paid on investments such as ISAs are too low to tax.
C Taxpayers would otherwise transfer their savings offshore.
D The UK Government wishes to encourage citizens to save.
[2]
9 Which of the following could explain a significant difference between a company’s

basic earnings per share and diluted earnings per share?
A The company has convertible debt in issue.

B The company has fixed interest bonds in issue.
C The company plans to pay a substantial dividend.
D The company has recently made a large rights issue.
[2]
10 Which of the following would NOT be disclosed in a company’s statement of

changes in equity?
A An increase in the revaluation reserve

B The payment of a dividend
C The profit for the year
D The repayment of a significant loan.
[2]
11 Explain the relevance of a decrease in a quoted company’s share price for its board of
directors. [5]
12 The directors of a quoted company plan to make a major investment in a factory that
will be used to manufacture a new product that is in development. This will be
financed by a rights issue. The company’s Finance Director believes that the share
price will fall below the theoretical ex-rights weighted average price and has warned
the board of this.
Explain the factors that would determine the share price after the rights issue. [5]
13 A quoted company merged with a slightly smaller competitor as part of an expansion

strategy, but the acquisition has failed to deliver the planned synergies.
Outline possible reasons that would explain the problems associated with this merger.
[5]
CB1 S2021–4
14 Describe the usefulness of the Earnings Before Interest, Tax, Depreciation and
Amortisation (EBITDA) figure to financial analysts. [5]
15 Explain why imposing a requirement on a company to report on its sustainability will

make little real change, unless the board wishes to behave in a socially responsible
manner. [5]
16 A major company exploited a loophole in an International Financial Reporting

Standard (IFRS) that permitted it to publish financial statements that complied with
the IFRS, but which were nonetheless misleading.
Describe the implications for the International Accounting Standards Board (IASB).
[5]
17 Explain whether businesses should aim to keep their working capital cycles as short
as possible. [5]
18 A company sells bicycles through a chain of 30 shops. Unit selling prices are set
centrally across the company. Shop managers are expected to motivate their sales
assistants and to ensure that sales revenue is maximised. They must achieve monthly
sales targets set by head office.
The company’s directors are considering a new system for encouraging shop
managers. The monthly sales targets will be withdrawn and replaced with the
publication of a monthly table that ranks the shops in terms of sales revenue. Any
shop manager who is in the bottom five places twice in a row will face dismissal.
Discuss the suitability of the proposed new system. [5]
CB1 S2021–5
19 T is an actuarial consultancy that was established 11 months ago. T is an unquoted
limited company. The company’s shares are held equally by the six founders, each of
whom is a director in the company.
T employs 50 staff in addition to the directors.
The company owns a large office building in the business district of Capital City. This
cost $2 million when it was acquired 11 months ago, but the building has recently
been valued at $2.4 million by a local property expert.
T’s directors have engaged an accounting firm to conduct the external audit of the
company’s first set of financial statements. These will cover the company’s first full
year of operation and so they have not yet been prepared. However, T’s Chief
Accountant has been gathering information and has been briefing the directors on
some of the accounting issues that have to be decided.
T’s directors have instructed the Chief Accountant NOT to depreciate the company’s
buildings because they wish the first year’s reported profits to be as high as possible.
The Chief Accountant has refused to agree to this, arguing that the building must be
depreciated if the financial statements are to comply with International Financial
Reporting Standards and pointing out that the external auditor will also refuse to agree
to this treatment.
T’s Chief Executive has asked for an explanation of the logic behind charging
depreciation on an asset that is increasing in value. They have also asked whether
recognising the building at its valuation would enhance the company’s reported
performance.
(i) Give an appropriate response, with reasons, to the Chief Executive’s request
for an explanation of the logic behind charging depreciation on T’s office
building even though it is increasing in value. [7]
(ii) Describe, with reasons, possible actions that T’s external auditor will take in
response to any refusal to depreciate the building. [7]
(iii) Describe the likely impact that revaluation of the property will have on T’s
reported performance. [6]
[Total 20]
CB1 S2021–6
20 G is a quoted company that manufactures mobile phones. The company’s directors
are considering expanding by investing in a new factory that will be designed to
manufacture gym equipment. This will incorporate smart sensors that can track users’
exercise routines.
G’s beta coefficient is 1.3, based on historical observations. The directors believe that
the proposed investment in the new factory will make G’s future cash flows more
volatile, but will have the effect of reducing beta to 1.1, ignoring the effects of
funding the investment.
The funding of the proposed investment has yet to be decided. It may be in the form
of debt or equity.
(i) Discuss the significance of the fact that the calculation of G’s present beta
coefficient was based on historical observations. [7]
(ii) Suggest possible reasons why the investment in the new factory could have the
effect of increasing the volatility of G’s cash flows while reducing its beta. [7]
(iii) Evaluate the likely effect of the choice between debt and equity for the
funding of this investment for G’s beta. [6]
[Total 20]
END OF PAPER
CB1 S2021–7
EXAMINERS’ REPORT
September 2021
CB1 - Business Finance

Core Principles
Introduction
Sarah Hutchinson
December 2021

CB1 - Business Finance - Core Principles - September 2021 - Examiners’ report
The aim of the Business Finance subject is to provide a basic understanding of corporate
finance including a knowledge of the instruments used by companies to raise finance and
manage financial risk and to provide the ability to interpret the accounts and financial
statements of companies and financial institutions.
This paper examines basic finance including raising funds by a variety of methods,
statements. It also considers the basis of the preparation of statements and the information
needs of a variety of end users of financial statements. There is now some management
accounting in the syllabus so there are questions on topics such as budgeting and
performance management.
Different numerical answers may be obtained to those shown in these solutions

B. Comments on candidate performance i n this diet of the examination.
Performance was reasonable for many candidates. Many of the questions were answered
very well but a number of candidates appeared to be inadequately prepared, in terms of
not having covered sufficiently the entire breadth of the subject. The MCQ questions
were answered very well with high marks being achieved by many candidates. Some of
the short questions were answered well but some candidates did not answer what was
asked, most notably in Question 12, Question 19 and Question 20.
Questions corresponding to parts of the syllabus that are not frequently examined were
generally poorly answered (e.g. Q19 and part (ii) and (iii) of Q20). This highlights the
need for candidates to cover the whole syllabus when they revise for the exam and not
only rely on themes appearing in past papers.
C. Pass Mark

Solutions for Subject CB1 - September 2021
Q1 B [2]
Q2 A [2]
Q3 A [2]
Q4 B [2]
Q5 B [2]
Q6 D [2]
Q7 A [2]

Q8 D [2]
Q9 A [2]
Q10 D [2]
Questions 1-10 were answered well by many candidates.
Q11
The share price reflects shareholder wealth. If the share price decreases then the
shareholders suffer a loss of value [1]
The shareholders could view the decrease as a sign that the directors have failed in their
duty to maximise shareholder wealth [1]
The directors cannot necessarily be expected to maintain the share price in all
circumstances and so they may not be responsible for any decrease [1]
Companies can suffer because changing consumer tastes affect demand or economic
events affect cash flows, none of which could be prevented [1]
The directors are unlikely to hold significant amounts of shares, so there will be no
direct loss if the share price decreases [1]
They could, however, be rewarded with share options or other forms of remuneration
that reflect share prices [1]
This question was answered well by many candidates, however some candidates did not
address the question of the directors and only discussed share price.
Q12
If the directors plan to make a rights issue then there will be a dilution effect that will
reduce the share price in line with the increase in shares, offset by the injection of funds [1]
The theoretical weighted average price can be calculated on the basis of the present
share price, adjusted for the effects of the rights issue itself [1]
The theoretical price assumes that the dilution effect is the only factor that will affect
share prices after the rights issue [1]
The share price reflects the market’s expectations of future cash flows. A rights issue
usually involves raising funds for a purpose, such as raising equity finance for a project [1]
If the market believes that the investment has a negative net present value then there will
be a loss of value that will further reduce the share price [1]
Presumably, the directors believe that the project has a positive net present value, but
that does not mean that the market will necessarily agree with that view and so the
share price could decrease [1]
This question was not answered well by candidates. Many candidates used information from
the study text and other sources to answer this question and did not answer what was asked.

Q13
It may be difficult to evaluate post acquisition synergies because the bidding company
will have limited access to the target company’s records, if any [1]
The directors of the target company may wish to resist the acquisition and could refuse
to grant any access to information that would assist the bidders [1]
For example, integrating IT systems can prove difficult and it may be difficult to tell
whether there will be a problem without first having access to the target’s IT staff [1]
Synergies may prove difficult to obtain in practice if the managers at the target company
choose to resist, even after acquisition [1]
For example, the synergies might require a reduction in staffing, but the target company
staff might act to keep as many jobs as possible [1]
Even though the target company is owned and controlled, its staff may be able to
undermine any attempts to introduce operating efficiencies [1]
Q14
The EBITDA figure is a reasonable approximation to the figure for cash from operations [1]
That figure will be of value in helping analysts track historical cash flows with a view to
understanding past volatility [1]
It could be argued, though, that there is very little need to calculate EBITDA because
the cash flow statement will give a more detailed breakdown of cash flows, including
cash from operations [1]
The EBITDA figure has the advantage of reflecting operating profit without any
allowance for subjective estimates such as depreciation and amortisation [1]
The figure comprises operating activities that are reflected by transactions and so they
are less subject to distortion by manipulation of estimates and should be more readily
comparable between companies in the same industry [1]
EBITDA does, however, ignore important costs, such as depreciation, and so it could
overstate performance [1]
In general this question was answered well.
Q15
If companies are required to report on their social responsibility then they may respond
by modifying their behaviour in response in order to maintain and enhance their
reputations [1]
The directors will be aware that customers might be reluctant to buy products made and
sold by companies that behave in an unsustainable manner [1]
The shareholders may also be reluctant to own shares in companies that are operating
in a manner that is harmful to the environment [1]
Any such pressure will, however, be offset by the fact that the board’s primary duty is
to maximise shareholder wealth [1]

The shareholders may wish to encourage companies to avoid major excesses in terms
of irresponsible behaviour, but there is a limit to the extent to which they will tolerate
reduced dividends in order to achieve that [1]
Social responsibility cannot be measured and evaluated to the same extent as cash flows
from operations and so there is a limit to how much impact this will have on behaviour [1]
This question was not answered very well. Most candidates scored some marks for discussing
sustainability but few answered the question asked. Some candidates were able to show
understanding of the problems of sustainability and the link to share price.
Q16
There have been cases such as this in the past and they have been labelled “accounting
scandals” [1]
In general, they have had a significant impact on the credibility of financial reporting
and the regulators who are responsible for it [1]
The fact that the misleading financial statements do not breach the rules suggests
incompetence on the part of standard setters [1]
These cases also highlight the extent to which the subjects of accounting regulation are
prepared to go in order to manipulate their reported results [1]
The fact that accounting standards are studied closely with a view to finding loopholes
indicates that standard setters must think ahead and take much greater care in setting
standards that leave very little scope for interpretation [1]
Paradoxically, the need to prevent such behaviour could lead to standards that are more
prescriptive and that leave less room for the application of professional judgement [1]
Some candidates answered this quite well, others found this question difficult.
Q17
A short working capital cycle generally implies that fewer net assets are tied up in
working capital [1]
That is desirable because working capital does not offer any return, so funds are being
invested in a manner that generates no reward [1]
The working capital cycle can be shortened in two basic ways, by speeding up the
liquidation of current assets and the slowing down of settlement of trade payables [1]
Cash management generally requires that attention should be paid to those balances in
any case [1]
There can be risks attached to a very short working capital cycle because companies
can lose business if they press receivables too hard for faster payment or lose sales if
they have insufficient inventory to meet demand [1]
They can also lose trade credit if they delay payments to suppliers for too long [1]

Q18
This approach to budgeting avoids the dilemma that setting specific targets can lead to
dysfunctional behaviour [1]
The new system will overcome the natural resistance of shop managers to agree to work
towards targets that are perceived as testing and so there could be a need to invest senior
management time in imposing the targets [1]
There will also be less scope for the manipulation of revenues, such as putting less
effort into sales once the target has been met because the target could be increased even
further if a shop has a good period [1]
The new system will effectively put the different shops and their managers in
competition with one another [1]
There will be no incentive to slack or to debate performance because the targets are
essentially being set by other shops in the chain [1]
This could, however, put the shop managers under a great deal of stress, which might
damage efficiency if they are struggling to break out of the bottom part of the table [1]
This question was answered well with many candidates discussing "beyond budgeting".
Q19
(i)
The purpose of depreciation is to recognise that items of property, plant and equipment
have finite useful lives [1]
It is, therefore, appropriate to write off their book values by depreciating them in order
to recognise that their lives have been partly consumed [1]
Depreciation is about recognising an expense in the statement of profit or loss rather
than correcting the value in the statement of financial position [1]
The increase in the value of the buildings is a medium term phenomenon that will
reverse eventually when the buildings reach the ends of their useful lives [1]
The buildings will eventually deteriorate and will have a value of zero regardless of
how the property market moves in the shorter term [1]
Buildings are generally depreciated at a low rate, possibly 2% of cost, to reflect the
fact that they may have lives of up to 50 years [1]
The need to depreciate buildings has been debated and resolved by the accountancy
profession [1]
There is an accounting standard that requires all tangible non-current assets with finite
lives to be depreciated [1]
The directors cannot, therefore, decide independently that they disagree with that logic
because there are rules in place to ensure consistency [1]
(ii)

The external auditor is required to form an opinion on the truth and fairness of the
financial statements and to express that opinion in the audit report that is attached to
the financial statements [1]
As part of that duty, the auditor must review the accounting policies being applied by
the directors to ensure that they are consistent with standards and with good
accounting practice [1]
In this case, the depreciation policy is unacceptable and the auditor will have to decide
whether that leads to a material misstatement of the reported figures [1]
If the failure to depreciate does lead to a material misstatement then the first thing
that the external auditor should do is meet with the directors to explain that there is
a problem [1]
Ideally, the auditor will be able to persuade the directors to change their decision, in
which case the buildings will be depreciated and the problem will be resolved [1]
If the auditor cannot persuade the directors to change then the next step would be to
warn them that the auditor will have both a legal and professional duty to bring these
problems to the attention of the shareholders [1]
The auditor will have to insist on a modified audit opinion [1]
The failure to depreciate the buildings will overstate profit and asset values by a
material amount and so the auditor will have to make it clear that there is a
disagreement over the accounting treatment [1]
The audit report will state that the financial statements give a true and fair view
“except for” the omission of depreciation [1]
(iii)
The revaluation will increase the book value of the buildings, which will increase the
amount that has to be written off over their useful lives [1]
The annual depreciation charge is likely to increase, thereby reducing profit [1]
The only way to avoid that would be to review the estimated useful lives of the
buildings with a view to extending the life and so offsetting some of the increase in
depreciation by dividing a larger book value by a larger life [1]
The performance will also be impacted by the fact that the revaluation will increase the
revaluation reserve balance [1]
That means that capital employed is larger and so return on capital employed will be
reduced [1]
Thus, the profit figure is likely to be smaller in absolute terms and will almost
certainly be smaller in relation to the resources that have been invested [1]
[Total 20]
This question was not answered well. Candidates struggled with part (i) and few candidates
were able to say in any depth why buildings should be depreciated.
Part (ii) was not answered well, many candidates wrote everything from the study text and
other sources on different types of audit reports which did not answer the question asked.
Many candidates relied on rote learning and did not apply their knowledge to the question
asked. Some candidates gave excellent answers to this question.
Answers to part (iii) represented an improvement relative to part (ii), but few candidates

answered well, again this was mainly due to a reliance on rote learning which meant
candidates did not answer what was asked.
Those who answered well understood that depreciation would increase after the revaluation
and were able to discuss the changes in return on capital employed very well.
Q20
(i)
Beta is calculated on the basis of the apparent sensitivity of returns on this company’s
shares to changes in returns on the market portfolio [1]
That ensures that the beta calculation is based on objective observations and can be
taken over a significant period of time [1]
The basis on which beta is calculated is well established [1]
The drawback with the use of historical data is that there is no reason to believe that
beta will remain unchanged over time [1]
The economic factors that drive the capital markets might change. The company
itself might also be managed differently or be affected by a change in circumstances [1]
For example, oil prices might become less volatile, which could have an impact on the
market portfolio, but could also have a significant impact on the relative volatility of,
say, an airline that uses a great deal of oil [1]
The danger is that beta is generally used in forward-looking decisions about investing
or retaining investments [1]
If the beta coefficient is based on outdated observations then the decisions will be badly
informed and so the wrong decision may be made [1]
In this case, the decision that is being made is a long-term investment in a factory, so
the cost of unwinding an incorrect decision will be significant [1]
(ii)
The new factory would increase absolute volatility if the underlying business is highly
volatile and risky [1]
The company presently manufactures mobile phones, which are a relatively well
established and mature product and so demand should be relatively steady [1]
The new factory will make a completely new product range that may have extremely
volatile demand [1]
This is a product that has not yet been proven and so demand could fluctuate
significantly, perhaps being affected by reviews or concerns about product safety [1]
It is also possible that competing products will emerge that will rob the product of
revenue, so the greater volatility may not be entirely within the company’s control [1]
The risks associated with the new product may be largely unsystematic risks, which
means that they can be diversified away [1]
If that leaves only a small residue of systematic risk then the investment will have a
small beta [1]
The overall beta for the expanded company will be the weighted average of the betas
for the existing company plus that of the new business [1]
That means that the overall beta will decrease provided the gym equipment business
has a beta of less than 1.3 [1]

(iii)
Gearing generally increases systematic risk, which means that the use of debt will
increase beta [1]
That can be demonstrated by calculating the geared and ungeared betas for the company
[1]
The ungeared beta is basically the beta arising from the systematic risks associated with
the business activities [1]
The geared beta increases that figure to take the effect of gearing for systematic risk into
account [1]
The geared beta is calculated by multiplying the ungeared beta by the figure
(1 + debt:equity*(1-tax rate)) [1]
That value is greater than 1, so the geared beta will always be greater than the ungeared
[1]
One way to think about geared beta is that the borrowing will make the company’s
exposure to changes in economic variables even greater and so it should increase beta [1]
[Total 20]
Candidates found all parts of this question difficult. Candidates dealt with part (i) best but
most answers were very generic. A number of candidates demonstrated a very good
understanding of Beta.
Part (ii) candidates did not apply their knowledge to the scenario. Many candidates could not
apply their knowledge of beta to a scenario however, some candidates did show they
understood diversification and Beta very well which was good to see.
Part (iii) was also weak, candidates did gain some marks for discussing geared beta but in
general the answers did not score well. Some candidates were excellent and were able to
discuss geared beta well and apply it to the question asked.
[Paper Total 100]

EXAMINATION
14 April 2022 (am)

Core Principles
Time allowed: Three hours and twenty minutes
If you encounter any issues during the examination please contact the Assessment Team on
T. 0044 (0) 1865 268 873.

1 Which of the following is most likely to seek a microloan?
A A charity that is attempting to raise the cost of a minibus to transport

volunteers
B A qualified actuary who requires funding in order to rent an office and start a
consultancy
C A subsidiary in a group of companies that requires finance to replace
equipment
D An unemployed carpenter who wishes to buy basic tools in order to start a
small business.
[2]
2 Which of the following statements is true of an interest rate swap?
A The need to use swaps implies poor financial management by the parties.
B The parties to the swap become responsible for one another's liabilities.
C The parties to the swap effectively make offsetting payments to one another
for the swap's duration.
D There are no credit risks associated with swap arrangements.
[2]
3 A quoted company is making a rights issue.
A Shareholders are required to exercise their rights.

B The new shares could be issued at a premium to the present market price.
C The new shares could be issued at a price that is less than their nominal value.
D The share price could increase after the issue.
[2]
4 A company is obtaining a stock exchange quotation through an offer for sale by

tender.
A All applicants will receive shares.

B All shares will be issued at the same price.
C Applicants making low tenders will depress the share price.
D The size of the issue will be decided after the tender process.
[2]
CB1 A2022–2
5 A company offers an automatic dividend reinvestment plan.
Which of the following statements is true with regard to the shareholders who are
enrolled in this plan?
A No tax will be paid.

B Shareholders will receive free shares.
C The new shares will be acquired at a discount.
D There is no benefit to the company.
[2]
6 The purpose of an ‘emphasis of matter’ paragraph in an external auditor’s report is to:
A draw attention to a note to the financial statements.

B explain a problem that arose during the audit.
C highlight a major change to corporate strategy.
D summarise the limitations of an external audit.
[2]
7 Which of the following reflects the accruals concept in the preparation of an insurer’s
financial statements?
A accounting for claim costs and premiums in the same period

B determining costs based on pessimistic assumptions
C excluding potential claims that cannot be measured objectively
D recognising estimated costs of settling recent claims as expenses
[2]
8 A parent company owns a single subsidiary that was purchased for cash 10 years ago.
Which of the following best explains the need to include the goodwill on acquisition
of this subsidiary in the consolidated statement of financial position?
A Goodwill always appears in the consolidated financial statements.

B Shareholders need to be reminded of the value of loyal customers and similar
intangibles.
C The goodwill was paid for and must be included or the statement would not
balance.
D The shareholders would otherwise be misled because the group's assets would
otherwise be understated.
[2]
9 Which of the following best describes ‘other comprehensive income’?
A dividends receivable
B gains that are taken directly to reserves
C income from financial assets
D income from operations
[2]
CB1 A2022–3
10 Which of the following best describes the attitude that a company should have
towards meeting its competitors’ information needs when preparing its financial
statements?
A Competitors are legitimate users of financial statements.

B Competitors have no means of obtaining the financial statements, so their
interest is irrelevant.
C Information that is of value to the shareholders is likely to be useful to
competitors.
D Information that would assist the competitors should be withheld.
[2]
11 Describe the challenges of identifying and evaluating the opportunity costs of an

investment project. [5]
12 Outline the advantages of setting a standard hurdle rate of, for example, 15% p.a. for
all investment projects undertaken by a large company. [5]
13 A film studio is about to start production of an action film. The film stars a major
actor who wishes to perform their own stunts. The studio is concerned that the actor
will be injured during filming.
Outline, with reasons, a suitable approach to mitigating the risks associated with the
actor performing stunts. [5]
14 Describe the implications of agency theory for the regulation of corporate governance.
[5]
15 Outline why requiring large oil companies to publish sustainability reports will
encourage them to behave in a manner that is socially responsible. [5]
16 A quoted company’s board wishes to treat a large payment as an investment in an

intangible asset, but the company’s external auditor insists that the payment should be
treated as an expense. The board’s proposed treatment will result in a significantly
higher reported profit and a stronger statement of financial position.
Explain the governance mechanisms that are in place to ensure that the board cannot
pressurise the external auditor into agreeing to a potentially misleading accounting
treatment. [5]
CB1 A2022–4
17 An engineer has invented a new electric motor that can be fitted to bicycles. She
believes that her invention has significant commercial potential because it will retail
for $600 per unit, which is substantially cheaper than existing products, all of which
are technically inferior.
The engineer has a working prototype, but she cannot afford to launch it unless she
can raise the $400,000 that it will cost to have an initial batch of motors manufactured
and to cover initial marketing.
Explain whether crowdfunding will be a suitable means for the engineer to raise the
$400,000 that she requires. [5]
18 The directors of an actuarial consultancy are working on next year’s annual budget.
The manager in charge of staff development has requested an increase in the staff
training budget for next year.
Describe the challenges associated with determining an appropriate level of

expenditure on the consultancy’s staff training. [5]
19 A quoted manufacturing company has recently appointed a new Chief Executive

Officer (CEO). It is close to the year end and the newly appointed CEO is working
with the Finance Director on plans for the preparation of the company’s annual
The CEO has noted that the company’s land and buildings have always been shown at
cost less depreciation. The company owns a large plot of land that holds a factory that
was built 15 years ago and an office block that was built 12 years ago. The land is
shown in the financial statements at cost and the buildings are shown at cost less
depreciation, with depreciation charged at 2% of cost each year.
The CEO believes that the land and buildings are worth far more than their
depreciated cost and that the financial statements should use a revalued figure. They
have asked the Finance Director to make the necessary arrangements with a
professional valuer and also with the company’s external auditor.
(i) Describe the effects of the revaluation on the relevance and reliability of the
company’s financial statements. [7]
(ii) Outline the effect of the revaluation on the company’s return on capital
employed ratio and its likely impact on the share price. [6]
(iii) Explain why the external auditor should be consulted on the revaluation. [7]
[Total 20]
CB1 A2022–5
20 S is a major quoted transportation company that operates 2,500 Heavy Goods
Vehicles (HGVs), delivering goods on behalf of several hundred customers, including
manufacturers and supermarkets. In addition to 5,000 drivers, S employs 300
administrative staff, most of whom are based in the company’s operations centre. The
operations centre uses sophisticated computer software to track the navigation
systems in S’s HGVs, and to schedule collections and deliveries, to maximise
operating efficiencies.
S’s board is considering the acquisition of G, a competing quoted transportation

company that operates 1,200 HGVs and employs 2,600 drivers and 170 administrative
staff. G also has a computerised operations centre that tracks HGVs and schedules
collections and deliveries. G’s market capitalisation is currently roughly half that of S.
Confidential meetings have taken place with G’s directors, who have agreed to
support the bid. S will issue new shares worth 15% more than G’s present market
capitalisation and will exchange those for 100% of G’s equity. S’s board is confident
that synergies will bring about a significant increase in the overall value of the merged
group.
G’s directors will step down after the merger, in return for a generous financial
settlement. The merged group will be managed by S’s existing board, whose
remuneration will increase in line with the increase in the size of the merged entity.
(i) Discuss the expectation by S’s board that this merger will bring about
significant synergies. [10]
(ii) Evaluate the proposal that G’s directors should receive a generous financial
settlement when they step down. [5]
(iii) Evaluate the proposal that S’s directors should be paid more in recognition of
the increase in the size of the merged entity. [5]
[Total 20]
END OF PAPER
CB1 A2022–6
EXAMINERS’ REPORT
April 2022
CB1 - Business Finance

Core Principles
Introduction
particularly the open-ended questions in the Specialist Advanced (SA) and Specialist
Principles (SP) subjects, the report may contain more points than the Examiners will expect
from a solution that scores full marks.
Sarah Hutchinson
July 2022

The aim of the Finance and Financial Reporting subject is to provide a basic understanding of
corporate finance including a knowledge of the instruments used by companies to raise
finance and manage financial risk and to provide the ability to interpret the accounts and
financial statements of companies and financial institutions.
preparation of the main financial statements and interpretation of financial statements. It also
end users of financial statements. There is now some management accounting in the syllabus
so there are questions on topics such as budgeting and performance management.
candidates are not penalised for this. However, candidates may not be awarded full marks
where excessive rounding has been used and where insufficient working is shown.
B. Comments on candidate performance in this diet of the examination.
Performance was reasonable for many candidates. Many of the questions were answered very
well but a number of candidates appeared to be inadequately prepared, in terms of not having
covered sufficiently the entire breadth of the subject. The MCQ questions were answered
very well with high marks being achieved by many candidates. Some of the short questions
were answered well but some candidates did not answer what was asked, most notably in
Question 19 parts (i) and (iii) and Question 16.
C. Pass Mark


Q1 D [2]
Q2 C [2]
Q3 D [2]
Q4 B [2]
Q5 C [2]
Q6 A [2]
Q7 D [2]
Q8 C [2]
Q9 B [2]
Q10 C [2]
Questions 1-10 were generally well answered by most candidates.
Q11
It will not always be clear what projects will have to be sacrificed in the event that a
particular project proceeds [1]
It may be that the directors only have a fixed amount budgeted for new investments,
but that does not necessarily mean that using those funds for one project will stop
others going ahead [1]
Positive net present value projects can generally be financed on the basis that their
cash flows will cover the finance costs and so there is only a genuine opportunity cost
if the choice is being made between projects that are genuinely mutually exclusive [1]
Realistically, managers who identify and promote projects may not be aware of the
alternative approaches that could be used instead [1]
Identifying the missed opportunities could require considerable research in order to
identify alternatives that could be considered instead [1]
It can be difficult to predict cash flows with any certainty and so determining the
opportunity costs could require a significant amount of time and effort and may not
lead to an optimal decision [1]
This question was answered well by many candidates. Most candidates understood
opportunity cost very well and were able to discuss it in the context of project appraisal.
Q12
The net present value criterion is the only method of investment appraisal that is
entirely consistent with the concept of maximising shareholder wealth [1]
One of the problems associated with applying that concept is that each project should
be evaluated at an appropriate discount rate that takes account of the risks associated
with future cash flows [1]
Determining a suitable discount rate can be complicated, so setting a blanket rate across
the whole company will have the effect of simplifying the application of NPV analysis [1]

Setting a blanket rate will avoid the pressures associated with managers arguing for
reduced discount rates to justify projects that they are keen to promote [1]
The rate may not be perfectly suited to all projects, but it has been decided by the board
and so they can be satisfied that projects are achieving an acceptable benchmark rate [1]
The company can also track the success rate of projects to determine whether the 15%
threshold is leading to the acceptance of too many projects or too few [1]
This question was answered very well by candidates. Most candidates are very good at
discussing NPV. Most candidates managed to score well and discussed discount rates and
hurdle rates in some depth.
Q13
The most logical response would be to reduce the risks by assessing each stunt in
terms of the likelihood of injury and insisting that the actor is replaced with a stunt
double if the risks are too high [1]
If agreement cannot be reached over that then the risk might be reduced by filming all
major stunts at the conclusion of shooting [1]
That would not reduce the risk of injury, but it would mean that the actor would have
completed all other filming before the risk of being injured, at which point a stunt
double could take over [1]
There will also be the risk that the studio will be held responsible for any injury to the
actor and it might be possible to transfer that risk [1]
One possibility would be to take out insurance for the cost of settling any legal claims in
the event that the actor is injured while working for the company. That could be difficult
to arrange because insurers might regard the likelihood of a claim as being too high [1]
An alternative would be to transfer the risk to the actor by insisting that she signs a
waiver, accepting any and all risks of injury arising from stunt work [1]
This question was answered well by most candidates. Candidates gave lots of ideas about
the risks. The question was a little different from usual but candidates made very good
attempts at thinking of all possible risks and mitigations.
Q14
The organisations that are responsible for the management of corporate governance,
such as the UK’s FRC need to understand the pressures faced by company directors [1]
Board members are free to manage their companies in any way that they see fit
because the shareholders have little or no direct oversight beyond the annual report [1]
It follows that directors may not always seek the shareholders’ best interests when
they are making decisions if there is a conflict between their interests as agents and
those of the shareholders as principals [1]
It could be argued that the need to regulate corporate governance has emerged
because of scandals in which directors have misbehaved and have drawn attention
to agency problems [1]

Regulators are faced with the difficult task of regulating boards whose duties require
them to be free to make strategic decisions without necessarily seeking explicit approval [1]
Regulators face criticism if they do not prevent scandals that occur because of the abuse
of that lack of oversight and that would have been difficult to have regulated [1]
This question was answered reasonably well however, some candidates were unsure about
agency theory.
Q15
It could be argued that their very nature means that oil companies are viewed as
behaving in a manner that is unsustainable and that does not discourage them from
their ongoing operations [1]
For example, oil corporations are an extractive industry that it clearly consuming
finite resources and customers who buy oil-based products must be aware of that fact [1]
It is possible that the publication of sustainability reports will encourage some
reflection on the part of directors and stakeholders as to the extent to which socially
irresponsible behaviour might be addressed [1]
It is unlikely that oil companies would wish to be associated with social responsibility
reports that admitted to misbehaviour [1]
They might, for example, seek ways to offset the damage that they do, such as
encouraging carbon offset arrangements [1]
They are likely to be unwilling to be associated with misleading or distorted reports
that made them appear defensive and unwilling to acknowledge their responsibility [1]
This question was done reasonably well by many candidates. Candidates were able to
offer good ideas on sustainability reports and apply them to the oil industry. Many
discussed that the reports could be used to improve an oil company's reputation and may
not always be accurate.
Q16
The governance mechanisms relating to financial reporting are generally delegated to
the accountancy profession of the company in question. In the UK that role is managed
by the FRC [1]
The starting point for dealing with accounting issues is the requirement that quoted
companies prepare their financial statements in accordance with formal accounting
standards [1]
In this case, it would be possible to seek some resolution by applying the requirements
of relevant International Financial Reporting Standards (IFRS). Amongst other things,
the IFRS would set out benchmarks that can be used to establish whether this payment
satisfies the criteria for recognition as an asset [1]
The governance rules also lay considerable emphasis on the role of the external auditor
and in safeguarding the auditor’s independence [1]

The auditor will be protected by the need to comply with IFRS, which will go some
way towards offering an objective basis for resolving the disagreement between the
auditor and the directors [1]
The auditor’s independence is also a major element of governance regulations and so
any attempt to coerce the auditor into accepting a misleading accounting treatment
should fail because the auditor would simply refuse [1]
This question was not answered very well. Many candidates discussed the role of the
auditor and not the governance mechanisms that stop the company pressurising the
auditor.
Q17
This might be a suitable project for pre-payment crowdfunding, which would involve
the engineer demonstrating her prototype online and seeking to interest possible buyers [1]
She could then ask interested viewers to commit themselves to buying one of the first
batch of motors, perhaps offering a discount against her anticipated retail price [1]
Cyclists might be prepared to pay, say, $500 now in the expectation of receiving an
exciting new product as soon as it becomes available [1]
This is an exciting product that should appeal to potential buyers and that could be
advertised online at relatively little cost, simply by filming a demonstration and adding
a voice track [1]
From the engineer’s point of view, this could prove an expensive source of finance
because the discount will have to be large enough to motivate potential buyers [1]
It will also be inconvenient if the amount raised is insufficient because it will then be
necessary to reimburse customers, which will lead to delays in any progress with the
product [1]
This is a reasonably new section of the syllabus and most candidates did very well in this
question.
Q18
The training budget is complicated by the fact that it is difficult to determine the
benefits associated with a given level of expenditure [1]
Clients will be more likely to commission work from an organisation that has
well-trained and capable staff, but that will be difficult to quantify [1]
Excessive training will not just be a waste of fees, there will also be the question of
loss of chargeable hours for staff who are engaged in training [1]
There is also a tendency for managers to seek to justify additional expenditure in
their areas of interest [1]
The manager in charge of staff development will enjoy greater status if more time
and money is invested in training [1]
It will also make this area easier to manage because any shortcomings in staff
capability can be addressed by arranging a training course [1]

This question was answered fairly well by many candidates, however, some candidates
discussed budgets and did not always discuss training budgets. There were some marks
available for general discussion but those who specifically discussed training budgets
scored high marks.
Q19
(i)
It could be argued that showing property at its book value of cost less depreciation is
lacking in relevance [1]
The property is 12 years old and is being written off at one fiftieth of that amount
every year. The book value is 38/50 of the original cost 12 years ago [1]
That figure will be of very little relevance to most decision-makers. Arguably, it is
just a balancing figure that has to be inserted for bookkeeping purposes [1]
Showing the property at its valuation will give the shareholders a much clearer
understanding of the value of the resources that have been entrusted to the directors [1]
That will enable them to form a better idea of performance and also of whether they
should allow the company to continue as a going concern [1]
The value will also be relevant to any funding decisions because potential lenders
will prefer to have a clearer understanding of the value of any assets that are pledged
as security [1]
Reliability implies that the figure cannot be challenged as incorrect. It could be argued
that a book value of cost less depreciation is utterly reliable because the original cost
is an objective figure and the annual depreciation rate is known [1]
It could be argued that the book value has little real relevance, but there is no doubt
that it is a factual statement of the asset’s worth [1]
The problem with valuations is that they are inherently subjective. Buildings vary in
many ways, including in terms of location [1]
The property markets can give a rough guide as to the price at which land and buildings
are bought and sold, but there are significant differences between individual properties [1]
There is no guarantee that a potential buyer would be prepared to pay the estimated
market value of a building [1]
(ii)
Return on capital employed will decrease for two reasons. Firstly, the annual
depreciation charge on the buildings will increase because the revalued amount will
have to be depreciated over the remaining 38 years of the building lives [1]
That will increase the annual depreciation charge and so reduce operating profit [1]
The gain on revaluation will also be taken to the revaluation reserve, which will
increase equity [1]
The denominator will therefore be increased, meaning that a smaller figure will be
divided by a larger one [1]
The share price is unlikely to be affected because the capital markets would have been
aware of the basis on which the assets were valued [1]

It will be unlikely that publishing the estimated market value will take the markets by
surprise because any necessary adjustments will have been made in any case when
studying, say, the gearing ratio [1]
The share price is also a reflection of the future cash flows from the business and so
the markets may not be greatly interested in the market value of the property [1]
If we assume that the company is unlikely to sell its property then it could be argued
that the market price is irrelevant and so will not constitute significant information [1]
(iii)
The external auditor is required to form an opinion on the truth and fairness of the
financial statements and to publish that opinion in the audit report attached to the
annual report [1]
Any change in accounting choice will have to be discussed with the external auditor
in order to ensure that the treatment follows accepted accounting principles and so does
not threaten the truth and fairness of the financial statements [1]
The auditor has to gather evidence as part of the process of forming an opinion [1]
In this case, the auditor will have to be satisfied that the adjustments being made are
credible and that the basis being used by the valuer is acceptable [1]
Ideally, the person providing the valuation will be an expert who can provide a credible
figure without any concerns about manipulating the value to meet the directors’ needs [1]
The auditor would also wish to review any evidence collected by the valuer such as
comparable properties that have been sold and any calculations [1]
If the auditor is dissatisfied with the information provided by the company then it will
not be possible to attach a clean audit opinion to the financial statements [1]
The auditor would have to describe the uncertainties associated with the property
and state that the financial statements gave a true and fair view, except for those
uncertainties [1]
[Total 20]
Part (i) was not answered very well by a number of candidates. The difference between
relevance and reliability was not really covered well in many answers. In part (ii) only
well prepared candidates discussed the possible effect of the revaluation on the share
price. Part (iii) many candidates were unclear about why the auditor should be involved
in the revaluation.
Q20
(i)
There are two obvious sources of synergy in this case. The first is the merger of the two
fleets of HGVs and the second is the savings in combining the administrative functions
of the two companies [1]
Synergy will be obtained if the merged entity can operate at a reduced cost compared
with the total running costs for the two separate entities [1]
Combining the two HGV fleets will create synergy if there are savings in running costs,
which might be created in several ways. The combined fleet is larger, so the merged
entity will have greater bargaining power when it needs to replace vehicles and so its
unit costs will be reduced [1]

That would only be possible if the merged entity can use a single supplier for
vehicles, otherwise the potential increase in bargaining power will not exist [1]
The larger fleet and the increased number of customers might also enable savings in
operating costs if journeys could be optimised to reduce the distances being travelled
and the number of empty vehicles [1]
With a larger entity, it may be easier to combine loads so that there is less wasted
capacity. It may also be more likely that a vehicle that has just made a delivery will be
able to take on a fresh load from nearby [1]
That synergy is probably quite realistic
The closure of the smaller of the two operations centres would be viable, but only if
the systems were compatible. If the vehicles are fitted with different satnav systems,
then it may be impossible to merge the operations centres [1]
If the centres cannot be merged then any hoped for synergies in operations may also
be lost because it will be difficult for the collection and delivery schedules to be
optimised across the merged entity [1]
The two administrative functions could also be merged so that efficiencies can be
created in those areas [1]
That will depend on the compatibility of the two systems. If they are not compatible,
then it may cost more to convert files than the savings that were hoped for [1]
The optimisation of resources could also create some significant problems with
morale and the willingness of staff to cooperate [1]
If the target company loses too many staff then those who remain may start to
become nervous and to assert themselves. Industrial action could discourage the
company from implementing plans to reduce costs [1]
(ii)
The financial settlement will reduce the threat of the directors blocking the merger in
order to keep their jobs [1]
Clearly, the company will require only one board and it is unlikely that the directors
of the larger entity will be willing to step down even if their counterparts in the other
company are better qualified [1]
Making this arrangement clear from the outset will reduce the uncertainty for the
outgoing board members because they would otherwise have to negotiate redundancy
terms after the merger [1]
There is a risk that the financial settlement will create a conflict of interest when
negotiating the terms of the merger [1]
The directors should be focussed on taking care of their shareholders’ interests, but
they could be side-tracked by a desire to protect their severance package [1]
The shareholders might also resent the decision to pay a substantial redundancy
payment to outgoing directors [1]
(iii)
One of the foundations of corporate governance is that company directors should be
paid a realistic reward for the work that they do [1]
They should receive sufficient to attract and retain suitably qualified directors, but
they should not be overpaid [1]
Their rewards should be aligned to the shareholders’ interests [1]

The directors are essentially responsible for the company’s strategic management [1]
It is debateable whether it will be more difficult or harder work to manage the merged
entity just because it is 50% bigger [1]
If the shareholders agree to that then they may be creating pressure for the directors
to expand further by acquisition so that their salaries increase by even more [1]
[Total 20]
Candidates generally scored well at part (i) with most coming up with good ideas of
synergies, Part (ii) was less well answered with many candidates discussing director's
remuneration rather than severance. Part (iii) was generally well answered with most
candidates discussing the points on remuneration well.
[Paper Total 100]

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Faculty of Actuaries Institute of Actuaries

8 April 2005 (am)

Subject CT2 Finance and Financial Reporting

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

3. Mark allocations are shown in brackets.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

A Dividends were lower this year than last year.

A increase the current ratio

B reduce the current ratio

C have no effect on the current ratio

D either increase or decrease the current ratio depending on the balances

The accounting concept which governs the above is the:

A the tax treatment of preference dividends

6 A business has decided to acquire a specialised piece of machinery using a finance

A On delivery of the asset.

A An adjustment to the balance sheet value to reflect market values.

B An adjustment to the balance sheet value to avoid overvaluing assets.

CT2 A2005 3 PLEASE TURN OVER

B To explain any increase or decrease in the business s working capital.

C To establish the ability of the business to pay its liabilities.

A The investor is keen to develop a relationship with a new broker.

C The investor is trying to stimulate the market s interest in the shares by

D The investor wishes to confirm the liquidity of the stock s market.

11 Company A has invested in Company B. Explain how the directors of Company A

13 Describe the role of the external auditor in financial reporting. [5]

15 The partners in a small business are considering becoming a limited company.

Explain whether incorporation would be likely to be a cost-effective way of avoiding

17 H is considering buying shares in a major quoted company, but is concerned by the

(a) Explain what is meant by dilution in this context; and

(b) Explain how it might affect H s investment.

(b) Indicate whether reducing the beta is likely to be desirable to potential

CT2 A2005 5 PLEASE TURN OVER

(iv) Explain why an unquoted company should be required to prepare financial

Subject CT2 Finance and Financial Reporting

11 The principal test is whether Company A can control Company B.

The probability tree would involve the following steps:

Any monitoring or covenants based on published accounts will be regarded as more

14 The markets demand an adequate rate of return from an investment.

18 (a) The most obvious way in which to reduce beta is to diversify.

Shareholders looking to build a clearly diversified portfolio might actually be

This might take account of the cost of the company s capital.

The Modigliani and Miller

This argument ignores taxation, though.

The asset basis may be more appropriate if the business is to be sold as it

(iii) With most information gathering systems there is normally a trade-off

The financial statements are generally prepared on the basis of highly

The financial statements enable shareholders to make decisions about their

Companies also require financial statements in order to pay tax.

END OF EXAMINERS REPORT

9 September 2005 (am)

Subject CT2 Finance and Financial Reporting

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

3. Mark allocations are shown in brackets.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.