Examination: Subject CT2 Finance and Financial Reporting Core Technical

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.
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
Finance charges (870)
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
Current liabilities 414

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
Revaluation reserve 164
Retained earnings 342
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.
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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:
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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
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Examination: Subject CT2 Finance and Financial Reporting Core Technical

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Examination: Subject CT2 Finance and Financial Reporting Core Technical

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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.

AT THE END OF THE EXAMINATION

1 The following information is available for A Ltd:

Authorised shares Issued shares

2 Which of the following is NOT true of a Limited Liability Partnership (LLP)?