May 2002 Examination Subject 108 :- Finance and Financial Reporting Indicative solutions

1D 2B 3D 4A 5C 6E 7C 8A 9A 10 B 11 D 12 C 13 E 14 B 15 B 16 C 17 E 18 D 19 E 20 A 21 A 22 D 23 A 24 D 25 E 26) Life insurance companies are major institutional investors and, collectively, are amongst the very largest institutions. The companies collect cash from policy holders and invest this in the long term. Policy holders will normally be offered the expectation of a future bonus based on the profits of the company. This has the effect of requiring insurance companies to seek out investment opportunities which both offer the prospect of maintaining the real purchasing power of their deposits and also a realistic expectation of capital growth. Insurance companies are also subject to a number of regulatory constraints on the nature of their investments. These are partly attributable to the need to maintain solvency margins in accordance with regulations.

Any other relevant points.

27) Inflation: expectations of higher inflation are likely to lead to higher gilt yields and vice versa. Short term interest rates: reduction in short term interest will reduce yields on short gilts longer gilts yields may reduce by less or even rise if reduction in interest rates is viewed as a sign of monetary easing. Fiscal deficit: increasing PSBR is likely to put upward pressure on gilt yields, especially in the maturities in which the government is concentrating most of its funding. Exchange Rate: changes in the exchange rate will affect the demand from overseas investors and will alter the relative attractiveness of domestic and overseas bonds. Financial institutions: changes to institutional cash flow and investment policy will affect demand for, and hence the price of, gilts. Alternative Investments: the relative attractiveness of alternative investments eg equities, overseas bonds. [ 28) Increase in stock values: the value shown in the profit and loss account for increase in stocks of finished goods and work in progress will be positive if the money value of stocks held is increased due to inflation even if the real volume of stocks held is constant. This will tend to overstate profits. Depreciation: the depreciation charge will be calculated using the historic cost of the assets. This will tend to overstate profits. Interest payments: a company may receive interest on its investments, and pay interest on its loan capital. In times of inflation, part of the interest payment is really compensation for the erosion of the real value of capital. For a company that pays out more interest than it receives, profits will tend to be understated in times of high inflation. Value of assets: the real value of all the companys assets will be eroded by inflation if their values stay constant in nominal terms. Consistency over time: profits and asset values might be increasing in money terms. But it would not be immediately obvious how much was due to a real increase in the scale of a companys operations and how much was simply due to inflation. Comparison between years is therefore difficult when using historic cost accounts.

29) i) Share capital is the most flexible form of finance. The payment of dividend is entirely at the discretion of the directors. If the dividends are withheld for any reason then the shareholders have no direct sanctions against the company, other than the right to sell their shares on the open market. Issuing fresh share capital also makes it easier to raise further finance by borrowing. This is because lenders are usually keen to see the company maintain a sensible relationship between debt and equity. If the company fails then the lenders must be repaid in full before the shareholders receive anything. If the shareholders have financed a large proportion of the share capital then this protects the lenders from the loss of their principal. Share capital tends to be a rather expensive form of finance. This is because shareholders bear a much higher risk than lenders. They have to be rewarded with a substantial return in order to motivate them to accept this level of risk. In addition, the company does not receive any tax relief on dividends whereas loan interest is tax deductible. Issuing additional share capital will also tend to dilute the sense of ownership and control enjoyed by the present shareholders. They might be willing to forego the opportunity to expand if doing so would make them accountable to outside shareholders. Any other relevant points. (ii) The company ought to consider an offer for sale. This would involve selling new shares to the general public at a fixed price which was determined by the directors. The advantage of this is that it raises additional capital at the same time as introducing the company to the stock exchange. There is relatively little risk of this type of transaction going wrong because the company would sell the shares via an issuing house. The issuing house would act as an intermediary between the company and the public. In the first instance, the issuing house would purchase the shares from the company and then resell them to the public. This means that the company knows in advance how much the issue will generate because the issuing house is responsible for any lack of demand and will be left holding any unsold shares. The use of an issuing house also provides the company with a source of experience and advice in the selection of other professionals and in the coordination of their various efforts. Well before the offer for sale, the company will engage an issuing house. The issuing house will try to generate interest in the launch, e.g. by publicising positive news that might be picked up by the financial press. In the weeks before the launch, the issuing house will advise on the price that should be set. This will normally be a reasonably conservative figure, if only because a higher issue price would involve a greater risk for the issuing house and that might result in higher fees and premia.

The company is required to publish a prospectus, which is a formal document required by the stock exchange. This is a detailed document containing a wealth of historical and forecast information, both financial and non- financial. This information will also be supported by a number of assurances from the companys external auditors. The prospectus will also state the offer price for the shares. The prospectus will be reproduced in at least one national newspaper and may be distributed in other ways. Anyone wishing to purchase shares can do so during the period immediately after the publication of the prospectus. Hopefully, the offer price was set at a level that would encourage investment and the issue will be over-subscribed. This means that the issuing house will have to decide on the most appropriate basis for the allocation of shares. Finally, the successful applicants will receive letters of acceptance. Official trading on the stock exchange can take place on the day after the acceptance letters are posted.

30) XYZ Profit and Loss Account for the year ended 31 March 1999 Sales Cost of sales Gross profit Administration Distribution 600.0 330.8 269.2 33.0 51.5 84.5 184.7 124.7 102.7 Dividend Balance brought forward 80.0 22.7 83.0 105.7 XYZ balance sheet as at 31 March 1999 Fixed assets Current assets Stock 9.0 Debtors 70.0 Prepaid expense 2.0 81.0 Current liabilities Bank o/d Proposed dividend Taxation 3.0 80.0 22.0

Operating profit Interest 60.0 Net profit before taxation Taxation 22.0

555.7

Creditors Net current liabilities Loan

26.0 131.0 50.0

300.0 205.7 Share capital Profit and loss account 100.0 105.7 205.7 Working Fixed assets Factory Machinery Vehicles Total Gross block Dep upto the year Dep for the year Net block 290.0 22.0 5.8 262.2 290.0 80.0 29.0 181.0 220.0 70.0 37.5 112.5 800.0 172 72.3 555.7

Cost of sales Opening stock Purchases Closing stock Factory depreciation Machinery depreciation Factory rates and insurance Manufacturing wages Administration Office rates and insurance Admin wages Distribution Delivery wages Vehicles - depreciation

8.0 220.0 -9.0 5.8 29.0 15.0 62.0 330.8 12.0 21.0 33.0 14.0 37.5 51.5