CB1 Flashcards 2019

Business Finance
Flashcards
for exams in 2019
The Actuarial Education Company

on behalf of the Institute and Faculty of Actuaries
Introduction
These flashcards cover the key areas of the CB1 course that need to be
committed to memory. However, please appreciate that individuals may have
their own preferences. For example, you may prefer to learn even more
material than we have covered.
Each flashcard has questions on one side and the answers on the reverse
and hence we recommend that you use the cards actively and test yourself as
you go. However, you can use the reverse side of the cards as a standalone
revision tool if you prefer from time to time.
Flashcards may be used to complement your other study and revision

materials. They are not a short cut to success but they should help you learn
the essential material required for the Subject CB1 exam.
However, being able to use and apply the knowledge you acquire is equally
important and so it’s vital that you still practise lots and lots of questions (from
past papers, assignments from the ends of the chapters in the course notes)
as part of your revision.
© IFE: 2019
CB1
Chapter 1
CB1 Ch 1: Key principles of finance and corporate governance
1
Outline the TWO basic decisions involved in company finance.
© IFE: 2019 

Two basic decisions involved in finance
1. The capital budgeting (or investment) decision

What real assets should the firm invest in?
2. The financing decision

How should the cash for the investment be raised?
© IFE: 2019
2
In relation to a company’s financial decisions, outline the responsibilities of

the:
 Chief Financial Officer (CFO)
 treasurer
 board of directors.
© IFE: 2019 

Responsibilities for financial decisions
The Chief Financial Officer (CFO) is normally responsible for the capital
budgeting decisions. These decisions will be linked to the company’s
business plans and so will also involve managers from the company.
The treasurer is normally responsible for the financing decisions. The

treasurer:
 looks after the company’s cash
 raises new capital
 maintains relationships with banks, shareholders and other investors.
In practice, the CFO and the treasurer are sometimes the same individual.
Ultimately, the board of directors is responsible for all financial decisions.

Important financial decisions are made by the board, not delegated.
© IFE: 2019
3
Describe the contractual theory of the firm.
© IFE: 2019 

Contractual theory of the firm
Contractual theory views a firm as a network of contracts, actual and implicit,

which specify the roles of the various participants (eg workers, managers,
owners, lenders, etc) and define their rights, obligations and payoffs under
various conditions.
Most participants bargain for limited risk and fixed payoffs.
The firm’s owners are liable for any residual risk and hold a residual claim on
any assets and earnings of the firm that remain after covering costs.
© IFE: 2019
4
State TWO main advantages and ONE main disadvantage of the separation
of company ownership and management.
© IFE: 2019 

Separation of company ownership and management
Advantages
 Freedom for ownership to change without affecting operational activities
 Freedom to hire professional managers
Disadvantage
 Interests of owners and managers may diverge (principal-agent
problems)
© IFE: 2019
5
Outline agency theory.
© IFE: 2019 

Agency theory
Agency theory considers the relationship between a principal (eg a company’s

shareholders) and an agent of that principal (eg the company’s management),
including issues such as:
 principal-agent problems or conflicts of interest (and how to avoid them)
 the nature of agency costs (eg the costs associated with monitoring the
actions of others)
 how agents may be motivated and incentivised.
© IFE: 2019
6
Outline the theory of the maximisation of shareholder wealth.
© IFE: 2019 

Maximisation of shareholder wealth
Provided that a free, competitive, capital market exists, shareholders can

choose their investments to meet their needs for cashflow, risk appetite and
so on.
If we assume that all shareholders seek to be as rich as possible, then the

goal of the firm is to increase the market value of each shareholder’s stake in
the firm.
If managers are not performing effectively, it will not be long before this is
reflected in a lower share price. This may make the firm a bargain for a
corporate acquirer and a take-over bid may be made.
The presence of the capital markets' continuous assessment therefore

stimulates efficiency and provides incentives to business managers to improve
their performance.
© IFE: 2019
7
State FIVE key effects of the capital markets on a firm’s decisions.
© IFE: 2019 

Key effects of the capital markets on a firm’s decisions
1. Sound investment decisions require accurate measurement of the cost

of capital.
2. Limitations in the supply of capital focus attention on methods of raising

finance.
3. Mergers and takeovers create threats and opportunities to be exploited.
4. ‘Externalities’ require managers to determine the appropriate role of

organisations.
5. The capital markets' continuous assessment stimulates efficiency and

provides incentives to a firm’s managers to improve their performance.
© IFE: 2019
8
List the factors that affect the needs and objectives of shareholders.
© IFE: 2019 

Factors affecting the needs and objectives of shareholders
 Attitude towards risk

 Time preference and consumption needs
 Balance between the need for income and for capital growth
 Tax position
© IFE: 2019
9
Define corporate governance.
State the role of the following in UK corporate governance:

 boards of directors
 shareholders
 Financial Reporting Council (FRC).
© IFE: 2019 

Corporate governance
Corporate governance is the system by which companies are directed and

controlled.
Boards of directors are responsible for the governance of their companies.
The shareholders’ role in governance is to appoint the directors and the

auditors and to satisfy themselves that an appropriate governance structure is
in place.
The FRC is responsible for setting the UK Corporate Governance and

Stewardship Codes.
© IFE: 2019
10
State the FIVE headings that are the main principles of the UK Corporate
Governance Code.
© IFE: 2019 

UK Corporate Governance Code
1. Leadership
2. Effectiveness
3. Accountability
4. Remuneration
5. Relations with shareholders
© IFE: 2019
Summary Card
Financial decisions Cards 1 & 2
Contractual theory of the firm Cards 3 & 4
Agency theory Card 5
Capital markets Cards 6 to 8
Corporate governance Cards 9 & 10
© IFE: 2019 

CB1
Chapter 2
CB1 Ch 2: Business ownership
1
Name FOUR types of business entity.
© IFE: 2019 

Four types of business entity
1. Sole trader
2. Partnership
3. Limited company
4. Limited liability partnership
© IFE: 2019
2
Define a sole trader.
State the extent of a sole trader’s liability.
State the documentation required to set up as a sole trader.
© IFE: 2019 

Sole trader
A sole trader is a business which is owned by one person and which is not a
limited company. However, sole traders can have employees working for
them.
Liability
Sole traders have unlimited legal liability for their business debts.
Legal documentation
No specific documentation is needed to establish legally as a sole trader.
© IFE: 2019
3
Define a partnership.
State the extent of a partner’s liability.
State the documentation required to establish a partnership.
© IFE: 2019 

Partnership
A partnership is a business which is owned by more than one person and

which is not a limited company. The partnership may be owned in equal or
unequal amounts by the partners. Partners may be active or sleeping.
Liability
Partners have unlimited liability. All partners are jointly and severally liable for
the debts of the partnership.
Legal documentation
Strictly, no specific documentation is needed to establish legally a partnership

but most partnerships will have a partnership agreement which sets out the
rights of individual partners.
© IFE: 2019
4
Define a limited company.
State the extent of a shareholder’s liability.
State the legal and accounting documentation required to establish and run a
limited company.
© IFE: 2019 

Limited company
A limited company is a business which has a legal identity separate from the
owners of the business. Almost all limited companies are financed by the issue
of shares.
Liability
Shareholders in a limited company have their liability limited to the fully paid
value of their shares. (If shares have been issued partly-paid then, in the
event of a liquidation, shareholders will only be liable to pay the outstanding
instalments.)
Legal and accounting documentation

Limited companies must have a Memorandum of Association and Articles of
Association and those above a certain size (in terms of turnover, assets or
number of employees) must produce audited accounts each year.
© IFE: 2019
5
Define a limited liability partnership (LLP).
State the extent of the liability of a member of an LLP.
State the documentation required to establish an LLP.
© IFE: 2019 

Limited liability partnership (LLP)
An LLP is a vehicle that gives the benefits of limited liability whilst retaining
other characteristics of a traditional partnership. The LLP is a separate legal
entity.
Liability
Whilst the LLP itself is responsible for its assets and liabilities, the liability of its
members is limited (as the name suggests!).
Legal documentation
An LLP has no Memorandum or Articles of Association. An LLP is typically
governed by a partnership agreement. If there is no partnership agreement,
an LLP is governed by default provisions contained in regulations.
© IFE: 2019
6
Distinguish between public limited companies and private limited companies.
© IFE: 2019 

Public limited companies and private limited companies
A public limited company is a company whose documentation states that it is

a public company and which has an issued share capital of at least £50,000.
The name of a public limited company must end with the words ‘public limited
company’ (or the abbreviation PLC or plc).
All other limited companies are classed as private limited companies. A

private limited company’s name must end with the word ‘limited’ (or the
abbreviation LTD or ltd).
A private limited company is not allowed to offer its shares to the public.
It is a requirement of the Stock Exchange that a company that applies for a full
Stock Exchange listing must be a public limited company.
© IFE: 2019
7
Describe the advantages of limited companies.
© IFE: 2019 

Advantages of limited companies
 The main advantage is that limited liability makes it easier to raise

capital.
This allows large numbers of people to invest small amounts of money
in many different companies with relatively minimal checking of the
company’s prospects and this diversifies their risk.
This is particularly important for businesses with a risk of incurring
substantial debts and those requiring large amounts of capital.
 It allows separation of ownership and management so:

‒ share ownership can change without interfering with the operation
of the business
‒ firms are able to hire professional managers.
© IFE: 2019
8
State FOUR disadvantages of limited companies.
© IFE: 2019 

Disadvantages of limited companies
1. Once the company’s assets have been exhausted, creditors have no

way of ensuring payment.
2. Limited liability allows people to invest in shares without taking an active

interest in the long-term needs of the company.
3. The managers of a company may have aims which are not in the best
interests of the shareholders (the agency problem).
4. Problems of information asymmetries exist where different stakeholders

(managers, shareholders and lenders) have different information.
© IFE: 2019
Summary Card
Business entities Cards 1 to 5
Limited companies Cards 6 to 8
© IFE: 2019 

CB1
Chapter 3
CB1 Ch 3: Taxation
1
Personal taxation will typically be levied on all the financial resources of

individuals. List SIX such financial resources.
© IFE: 2019 

Taxable financial resources of an individual
1. Earned income, eg salaries
2. Unearned income, eg investment income, rental income
3. Profit from operating as a sole trader or partner
4. Inherited wealth
5. Investment gains
6. Value of assets held, ie wealth
© IFE: 2019
CB1 Ch 3: Taxation
2
State THREE practical considerations typically considered in designing a tax

system.
© IFE: 2019 

Considerations in designing a tax system
1. Tax cashflows (rather than wealth)
2. Tax in arrears
3. Tax revenue flows only ONCE in the hands of the recipient.
© IFE: 2019
CB1 Ch 3: Taxation
3
Give THREE examples of forms of income that are tax-free in the UK.
Give TWO example of expenditure on which tax relief is available in the UK.
© IFE: 2019 

Tax-free income in the UK
3. Most profits from gambling
4. Most forms of social security benefit
3. Income from certain investments, eg ISAs
Expenditure attracting tax relief in the UK
1. Contributions to approved pension schemes
2. Charitable gifts
© IFE: 2019
CB1 Ch 3: Taxation
4
Explain how an individual’s taxable income is calculated.
© IFE: 2019 

Taxable income
Earned income, eg salaries, wages + other income, eg pensions
+ Income in kind, eg medical insurance premiums paid by employer
+ Gross investment income
– Tax-free income
– Tax-free expenditure
– Allowances, ie personal allowance plus any additional allowances, eg a

dividend allowance.
© IFE: 2019
CB1 Ch 3: Taxation
5
Give FOUR examples of assets that are free from capital gains tax (CGT) for
individuals in the UK.
© IFE: 2019 

Assets free from CGT in the UK
1. Private motor cars
2. Main private residence
3. Foreign currency obtained for personal use
4. British Government securities and other qualifying fixed-interest stocks
© IFE: 2019
CB1 Ch 3: Taxation
6
Explain how a chargeable gain is defined for CGT purposes.
© IFE: 2019 

Definition of chargeable gain
A chargeable gain is typically defined as:
sale price  purchase cost
where:
 sale price can be reduced to reflect any costs associated with the sale
 purchase cost can be increased by any costs associated with the

purchase and any expenditure made to enhance the value of the asset
during the period the asset was held. In normal circumstances, the
purchase cost would be the original cost of the asset.
© IFE: 2019
CB1 Ch 3: Taxation
7
Give THREE examples of reliefs that are common in many countries and that
can reduce an individual’s taxable capital gain.
© IFE: 2019 

Reliefs from capital gains.
Capital losses can normally be offset against capital gains.
Individuals are given an allowance each year and only pay capital gains tax on
chargeable gains in excess of this amount.
Indexation allowance may be applied to the purchase price (not the case in
the UK).
© IFE: 2019
CB1 Ch 3: Taxation
8
State the rates at which individuals in the UK are taxed on capital gains.
© IFE: 2019 

Tax rates applying to capital gains in the UK
Individuals are taxed on capital gains at a flat rate of 10% or 20% (since April
2016), depending on their level of taxable income.
Higher rates can apply to some gains, eg second homes.
© IFE: 2019
CB1 Ch 3: Taxation
9
Companies are liable to corporation tax on their taxable profits. Explain how
taxable profits are determined.
© IFE: 2019 

Taxable profits for corporation tax
Taxable profits include both income (less allowable expenses) and capital
gains. The starting point is profit on ordinary activities before taxation,
ie accounting profit. This is then adjusted by:
 adding back any business expenses shown in the accounts which are
not allowable for tax, eg entertainment of customers, fines for illegal
acts
 adding back any charge for depreciation and instead subtracting capital
allowances
 deducting any special reliefs, eg R&D costs may be deducted
immediately.
(Additionally, the company may not have to pay further tax on dividends
received from any shareholdings in other companies, ie any franked income.)
© IFE: 2019
CB1 Ch 3: Taxation
10
Explain how governments can use the corporation tax system to influence
behaviour.
© IFE: 2019 

Government use of the corporation tax system to influence behaviour
Governments can:
 encourage companies to invest by using a lower rate of tax on

retained profit than on distributed profit
 encourage the setting up of pension schemes by allowing pension

contributions to be treated as an expense for tax purposes and
granting tax relief to investment earnings within the pension scheme
 encourage other activities (eg training, research and development) by

allowing similarly tax-advantaged funds.
© IFE: 2019
CB1 Ch 3: Taxation
11
Explain what is meant by an imputed tax system.
© IFE: 2019 

Imputed tax system
Some countries give relief to shareholders to ensure that dividends are not
subject to both personal and corporate income tax.
The company paying the dividend has already paid corporation tax on the
profits from which the dividend is paid. This dividend income is known as
franked income and the shareholders are imputed (or credited) at least part of
the tax.
So, an imputed tax system ensures that there is no disadvantage experienced

by the shareholder when a company distributes profits.
© IFE: 2019
CB1 Ch 3: Taxation
12
Describe double taxation relief (DTR).
© IFE: 2019 

Double taxation relief (DTR)
 DTR allows overseas tax paid in countries for which double taxation
agreements exist to be offset against the liability to domestic tax.
 DTR applies to individuals and companies with overseas income or

capital gains.
 The credit is equal to the lower of foreign tax paid and the domestic tax
due.
© IFE: 2019
CB1 Ch 3: Taxation
Summary Card
Personal taxation Cards 1 to 4
Capital gains tax Cards 5 to 8
Corporation tax Cards 9 & 10
Imputed tax system Card 11
Double taxation relief Card 12
© IFE: 2019 

CB1
Chapter 4
CB1 Ch 4: Long-term finance
1
Set out the main features of loan (debt) capital.
© IFE: 2019 

Main features of loan (debt) capital
It is a source of long-term finance. Issuing company pays the investor a

stream of interest payments plus an eventual return of capital. The interest
and capital payments to be made are specified at outset.
Investors are creditors (not owners) of the company and (unlike shareholders)
do not have voting rights.
Interest payments are tax deductible as an expense.
Loan capital may be listed on the Stock Exchange.
Prices quoted per £100 nominal (= par). Interest expressed as a % of par

value. Normally redeemed at par.
Market price can be greater or less than nominal value (depends on supply
and demand). Issue price normally equal to or just less than par.
© IFE: 2019
2
List SIX forms of debt capital.
© IFE: 2019 

Forms of debt capital
1. Debentures – mortgage and floating charge
2. Unsecured loan stocks (ULS)
3. Subordinated debt
4. Eurobonds
5. Floating-rate notes (FRNs)
6. Convertible ULS
© IFE: 2019
3
Describe the main features of debentures.
© IFE: 2019 

Debentures
A debenture is a secured form of loan stock.
Debentures are secured on some or all of the assets of a company. Therefore

if the company fails to make one of the coupon payments or the capital
repayment, various actions are available to the stockholders. They may
instruct the trustees to:
 appoint a receiver to intercept income from the secured asset(s),
eg rent on property
 take possession of the secured asset to sell it in order to meet their debt
(with any surplus being returned to the company), ie foreclose.
There are two types of debenture:

 fixed-charge (or mortgage) debentures
 floating-charge.
© IFE: 2019
4
Distinguish between mortgage debentures and floating-charge debentures.
© IFE: 2019 

Mortgage debentures
A mortgage debenture (also known as a fixed-charge debenture) has specific

secured assets mentioned in its legal documentation.
The company will be able to sell or make major alterations to these assets only
with the mortgage debenture holders’ (or the trustee’s) permission.
Floating-charge debentures
With a floating-charge debenture, the company can change the secured assets
in the normal course of business, eg sell the assets, so long as they are
replaced by equally satisfactory assets from the debenture holders’ (or the
trustee’s) viewpoint.
If the company fails to make an interest or capital payment, the debenture

holders (or trustee) can apply to the courts to crystallise the floating charge
into a fixed charge.
© IFE: 2019
5
List THREE risks of debentures from the holder’s point of view.
© IFE: 2019 

Risks of debentures from point of view of the holder
1. Coupon payments or capital repayment may not be made (but holders

do have the security of the assets backing the loan).
2. Value of payments (capital and interest) may be eroded by inflation.
3. Debentures may not be readily marketable.
The total expected return on debentures will reflect all these risks.
© IFE: 2019
6
Describe unsecured loan stocks (ULS).
© IFE: 2019 

Unsecured loan stocks (ULS)
A ULS offers no specific security for the loan, ie it is unsecured.
If the company defaults, the holders’ only remedy is to sue the company.
In terms of priority ranking for payment, ULS holders are:

 behind debenture holders
 equal with other creditors of the company
 ahead of shareholders.
© IFE: 2019
7
Define subordinated debt.
© IFE: 2019 

Subordinated debt
Subordinated debt is debt that ranks below the firm's general creditors
including other forms of debt (but ahead of preference shareholders and
ordinary shareholders).
It is sometimes called junior debt.
© IFE: 2019
8
Describe Eurobonds.
© IFE: 2019 

Eurobonds
Eurobonds are bonds issued in the Euromarket, ie without coming under the
legal or tax jurisdiction of any country. Eurobonds are marketed internationally,
mainly by London branches of international banks.
The main features of ‘typical’ Eurobonds are:
 unsecured
 bearer documents
 can be in any currency
 issued by companies and governments throughout the world
 annual coupon payment
 fixed coupons, redeemed at par
 mostly traded through banks rather than a Stock Exchange (although most
are listed).
However many ‘innovative’ Eurobonds have been issued. In particular, a
significant minority have variable coupons (floating-rate notes).
© IFE: 2019
9
Describe floating-rate notes (FRNs).
© IFE: 2019 

Floating-rate notes (FRNs)
FRNs are medium-term debt securities issued in the Euromarket that have
interest payments that float with short-term interest rates, possibly with a
stipulated minimum rate, ie an interest-rate floor.
The borrower loses the certainty of the known future repayment requirements
of a fixed-rate bond, but FRNs may be relatively attractive when interest rates
are high and companies are reluctant to borrow at a (high) fixed rate.
© IFE: 2019
10
Set out the main features of ordinary share (equity) capital.
© IFE: 2019 

Main features of ordinary share (equity) capital
Equities are a source of long-term finance. Ordinary shares give rights to a

share of the residual profits of the company, and to the residual capital value if
the company is wound up, together with voting rights and various other rights.
The shareholders are the owners of the business.
Dividend payments are made from a company’s profits. They are not a legal
obligation on the company and are only paid at the discretion of the directors.
In practice directors try to pay a steadily increasing stream of dividends.
Ordinary shares are the lowest ranking form of finance and rank after all
creditors.
Shares have a par or nominal value. They are almost always irredeemable.
The market price can be greater or less than nominal value (depends on
supply and demand). The issue price cannot be below par.
© IFE: 2019
11
Give FIVE examples of possible variations in ordinary shares.
© IFE: 2019 

Variations in ordinary shares
1. Deferred
2. Redeemable
3. Non-voting
4. Multiple-voting rights
5. Golden
The Stock Exchange discourages the issue of ‘non-standard’ ordinary shares.
© IFE: 2019
12
The marketability of the ordinary shares of a company is usually much better

than that of the loan capital of the same company. Outline THREE main
reasons for this.
© IFE: 2019 

Reasons for higher marketability of ordinary shares than of loan capital
1. Issues of ordinary shares tend to be larger than those of loan capital.
2. Ordinary shares tend to be standard whereas a company’s loan capital

is likely to be fragmented into several different issues.
3. Investors tend to buy and sell ordinary shares more frequently than they
trade in loan capital because the residual nature of ordinary shares
makes them more sensitive to changes in investors’ views about a
company’s prospects.
© IFE: 2019
13
Describe preference shares.
© IFE: 2019 

Preference shares
Preference shares:
 rank ahead of ordinary shares for payment of dividend and on wind-up
 normally pay a fixed dividend (provided company makes enough profits)
Dividends do not have to be paid, ie they are not a liability like debt
interest. If dividends are not paid on preference shares, no ordinary
share dividends can be paid.
 are usually cumulative and irredeemable
 do not usually carry voting rights (but usually do get voting rights if their
dividends are unpaid and when the rights attaching to their shares are
being varied)
 are much less common than ordinary shares
 are about as marketable as loan capital (and so less marketable than
ordinary shares).
© IFE: 2019
14
Give SIX examples of possible variations in preference shares.
© IFE: 2019 

Variations in preference shares
1. Non-cumulative
2. Redeemable
3. Participating
4. Convertible
5. Stepped
6. Paying variable dividends, eg dividends that are fixed relative to central

bank rates
© IFE: 2019
15
Describe convertibles.
© IFE: 2019 

Convertibles (CULS)
Convertible forms of company securities are ULSs or preference shares that

may be converted into ordinary shares of the issuing company.
The additional prospective return from ordinary shares means that the issuer
does not have to offer excessively high rates of interest / dividend prior to
conversion.
The date of conversion might be a single date or, at the option of the holder,
one of a series of specified dates. The investor does not pay anything to
convert.
If the holder chooses not to convert, then the security might continue as a ULS
or preference share for a period of time or it might be redeemed immediately
on a prescribed basis.
© IFE: 2019
16
In relation to convertibles, define:
 rest period
 conversion period
 conversion premium.
© IFE: 2019 

Convertible terminology
Rest period – the period prior to the first possible date for conversion
Conversion period – the period between the earliest and latest possible
conversion dates
Conversion premium – the difference between the ‘cost of obtaining one

ordinary share by purchasing the required number of convertible securities
and converting’ and the ‘market price of the share’. (Note – the convertible
premium is NOT a payment that has to be made in order to convert. No
payment is needed to convert.)
© IFE: 2019
17
Rank the principal forms of financial instrument a company may have issued
in order of riskiness, ie priority order for payment by company.
© IFE: 2019 

Ranking of financial instruments (from highest to lowest ranking)
1. Mortgage debentures and floating-charge debentures
2. ULS, convertible ULS, Eurobonds, FRNs and CULS
3. Subordinated debt
4. Preference shares and convertible preference shares
5. Ordinary shares
© IFE: 2019
18
Describe warrants.
© IFE: 2019 

Warrants
Warrants are call options (ie the right to buy the company’s shares) written by
a company on its own stock.
Typically, warrants last for a number of years.
When they are exercised, the company issues more of its own shares, ie the
exercise of a warrant leads to some dilution of ownership.
Prior to exercise, warrant holders are not entitled to vote or receive dividends.
Warrants are sometimes added to the issue of a fixed-interest stock. Once

they have been created, they sometimes trade separately from the bonds to
which they were originally attached.
Executive stock options are effectively warrants issued to senior managers as

part of their remuneration package. Their strike prices are intended to
represent a performance target for the senior managers.
© IFE: 2019
Summary Card
Loan or debt capital Cards 1 to 9, 17
Ordinary shares Cards 10 to 12, 17
Preference shares Cards 13 & 14, 17
Convertibles Cards 15 & 16, 17
Warrants Card 18
© IFE: 2019 

CB1
Chapter 5
CB1 Ch 5: Issue of shares
1
Distinguish between:
 being listed on the Stock Exchange
 being quoted on the Stock Exchange.
© IFE: 2019 

Stock Exchange listing and quotation
The terms listed and quoted are often used interchangeably, but strictly:
 listing is used to refer to being a member of the Stock Exchange main

market
 quotation can be applied to companies that are either a member of the

main market or the alternative investment market (AIM). AIM has less
stringent requirements for admissions.
Listed companies are therefore a subset of quoted companies.
© IFE: 2019
2
Give reasons why a company might seek a Stock Exchange quotation.
© IFE: 2019 

Reasons for seeking a Stock Exchange quotation
Main reasons
 To raise capital for the company
 To make it easier for the company to raise further capital in future
 To give existing shareholders an exit route, eg family business, venture
capital
Other reasons
To make the shares more marketable and easier to value. In particular:
 helps with tax calculations
 shares are more useful as backing for shareholder borrowing
 shares are a more effective offering as part of a takeover bid
 employee share schemes are more attractive.
© IFE: 2019
3
List FIVE methods of obtaining a quotation.
State which of these is most commonly used.
© IFE: 2019 

Methods of obtaining a quotation
1. Offer for sale at a fixed price
2. Offer for sale by tender
3. Offer for subscription
4. Placing
5. Introduction
An offer for sale at a fixed price is the most commonly used method.
© IFE: 2019
4
Describe an offer for sale at a fixed price.
© IFE: 2019 

Offer for sale at a fixed price
In an offer for sale at a fixed price, a predetermined number of shares (or

other securities) is offered to the general public at a specified price through an
issuing house.
The issuing house underwrites the issue.
The shares offered could be:

 new shares (if the company is seeking a quotation to raise money)
 existing shares (if the purpose of the quotation is to be an exit route for
the existing owners).
The issuing house also acts as professional adviser to the company,

overseeing the whole process and co-ordinating the activities of the other
professional advisers.
© IFE: 2019
5
Set out the steps in the offer for sale process.
© IFE: 2019 

Steps in the offer for sale process
 Try to ensure that pre-launch press comments are favourable

 Change company documentation to make the company a PLC
 Consider the price which should be set
 Prepare the prospectus
 At impact day:
– set the price
– launch prospectus (in at least one national newspaper)
 Applications received
 If oversubscribed, determine the basis of allocation
 If undersubscribed, underwriters take up remaining shares
 Post letters of acceptance and refund cheques
 Trading on Stock Exchange starts the next day
 Issue share certificates (In many countries electronic ‘paperless’ share
registration has replaced the traditional physical share certificate.)
© IFE: 2019
6
Describe an offer for sale by tender.
© IFE: 2019 

Offer for sale by tender
An offer for sale by tender is similar to an offer for sale at a fixed price, but the
issuing house invites applicants to submit a tender stating the number of
shares which they are prepared to buy and the price which they are prepared
to pay.
After closing, a single strike price is determined. This may be:

 the highest price at which all the stock can be allocated
 a lower strike price if this is necessary to ensure a sufficient spread of
shareholders.
All applicants who bid at least as much as the strike price will have their
applications accepted. Applicants who bid less than the strike price will have
their applications rejected. All successful applicants will pay the strike price,
regardless of how much more they had bid.
© IFE: 2019
7
Describe an offer for subscription.
© IFE: 2019 

Offer for subscription
An offer for subscription is similar to an offer for sale (either at a fixed price or
by tender) except the whole issue is not underwritten.
The issuing company sells shares directly to the public and bears (at least part
of) the risk of undersubscription.
Sometimes offers for subscription are used for unusual issues and launches of
investment trusts where it is uncertain whether investors will want to buy
shares, and how many can be sold.
An issuing house will still be employed as an adviser to the issue.
© IFE: 2019
8
Describe placings (or selective marketing).
© IFE: 2019 

Placings (or selective marketing)
In a placing the issuing house:
 first buys the securities from the company
 then offers them to a small number of its institutional clients.
No public applications are invited.
Placings are a simple and cheap method of making small issues.
© IFE: 2019
9
Describe introductions.
© IFE: 2019 

Introductions
Introductions do not involve the sale of any shares. They simply mean that
the existing shares will in future be quoted on the Stock Exchange.
For a full listing, 25% of shares must be in public hands. The Stock Exchange
only allows introductions in cases where this requirement is already met.
© IFE: 2019
10
List the steps in the underwriting process.
© IFE: 2019 

Underwriting process
Steps in the process:

1. The company arranges to sell all the shares at an agreed price to the
issuing house (and pays a fee to the issuing house).
2. The issuing house will probably not want to accept all the risk and so
will arrange sub-underwriting (and pay the sub-underwriters).
3. The main risk faced by underwriters is that an unexpected event
(adverse to the share price) occurs between accepting the underwriting
and the closing date for applications.
4. Either:
 Fully subscribed issue: The issuing house and the sub-
underwriters will have made an underwriting profit equal to their
underwriting commission less any expenses.
 Partly subscribed issue: The underwriters and sub-underwriters
get their fee / commission, but they also need to take up all the
shares that have not been purchased.
© IFE: 2019
11
Explain what a rights issue is and describe the main effects of a successful
rights issue.
© IFE: 2019 

Rights issues
A rights issue is an offer by a company to sell further shares, at a given price,

to existing shareholders in proportion to their existing holdings.
The purpose is to raise money for the company.
The main effects of a successful rights issue are:

 new shares are created
 new money is raised for the company
 the total value of the whole company should be increased by the extra
money raised
 the price per share will fall.
© IFE: 2019
12
Give a formula for the share price after a rights issue.
© IFE: 2019 

Share price after a rights issue (ie ex-rights price)
The price per share after a rights issue is:
original market capitalisation  extra value

P* 
new total number of shares
The factors incorporated within the extra value are:

+ the amount of new money raised by the rights issue
– the expenses of the issue
+/– the change in value based on the market’s revised perception of the
company and the use to which the money is being put.
When only the first of these three factors is considered, this is known as
calculating the theoretical ex-rights price.
© IFE: 2019
13
Companies can avoid the need to have a rights issue underwritten by setting
an offer price that is very low compared to the market price, ie issuing at a
deep discount.
List THREE possible problems with this approach.
© IFE: 2019 

Rights issues at a deep discount
1. Can increase CGT liabilities for those investors who choose to sell their
rights.
2. Companies are not allowed to issue shares below their par value which
places an upper bound on the size of the discount.
3. Can be interpreted by investors as a sign of weakness (inability to

obtain underwriting).
© IFE: 2019
14
Explain what a scrip issue is and describe the main effects of a successful
scrip issue.
© IFE: 2019 

Scrip issues
A scrip issue is an issue of free shares by a company to all ordinary

shareholders in proportion to their existing holding. No payment is required
from the shareholders.
The main effects of a successful scrip issue are:

 new shares are created
 no money is raised
 the value of the whole company is unchanged (the price per share
should fall in proportion to the increase in the number of shares)
 the total value of each investor’s holding should be unchanged
 shareholders’ reserves in the statement of financial position are
converted into share capital.
© IFE: 2019
15
List SIX possible reasons for a scrip issue.
List TWO disadvantages of a scrip issue.
© IFE: 2019 

Reasons for and disadvantages of a scrip issue
Reasons
Largely psychological
1. Improved marketability because of lower price
2. Idea of something for nothing
3. Past profitability (implied success)
4. Future confidence
5. Increased dividends
6. More reasonable rate of dividend
Disadvantages
1. Costs to the company, eg admin costs
2. Costs to everyone else, eg tax authorities when calculating CGT
© IFE: 2019
16
Give a formula for the share price after a scrip issue.
© IFE: 2019 

Share price after a scrip issue
On theoretical grounds, an n-for-m scrip issue should reduce the share price
from P to:
m
P
mn
This assumes that the market is totally indifferent to the scrip issue. The
actual change in the share price might move slightly one way or the other:
 up slightly if the psychological factors win through
 down slightly if the market decides that the cost of the issue outweighs
the benefits.
© IFE: 2019
Summary Card
Stock Exchange quotations Cards 1 to 10
Rights issues Cards 11 to 13
Scrip issues Cards 14 to 16
© IFE: 2019 

CB1
Chapter 6
CB1 Ch 6: Short- and medium-term finance
1
List FOUR forms of medium-term finance.
© IFE: 2019 

Four forms of medium-term finance
1. Hire purchase
2. Credit sale
3. Leasing
4. Bank loan (and loan facilities)
© IFE: 2019
2
Hire purchase agreements, credit sales and lease agreements all involve a
series of payments being made for an asset.
Describe how these three financing methods differ in respect of the ownership
of the asset.
© IFE: 2019 

Ownership of asset: hire purchase agreements, credit sales and lease
agreements
 Hire purchase agreements: legal ownership transfers when the final

payment is made.
 Credit sales: legal ownership transfers at outset.
 Lease agreements: legal ownership is not transferred.
© IFE: 2019
3
Describe hire purchase arrangements.
© IFE: 2019 

Hire purchase arrangements
A hire purchase agreement is an agreement to hire goods for a period of time,

making regular rental payments and to acquire the goods at the end of the
rental period without further payment.
Legal ownership passes to the buyer only when the final payment is made.
If the buyer fails to make the payments due under the hire purchase
agreement, the seller can take back the goods.
© IFE: 2019
4
Describe a credit sale.
© IFE: 2019 

Credit sale
A credit sale is a normal sale of a good together with an agreement that

payment will be made by a series of regular payments over a set period of
time. Legal ownership passes to the buyer at outset.
The seller cannot reclaim the goods even if the buyer defaults. All that the
seller can do is to sue for payment through the courts as with any other debt.
© IFE: 2019
5
Describe leasing and the TWO types of lease.
© IFE: 2019 

Leasing
A lease is an agreement where the owner of an asset gives the lessee the
right to use the asset over a period of time, in return for a regular series of
payments. Legal ownership does not change hands. There are two types of
lease:
1. Operating leases
Under an operating lease, the owner of the asset will retain most of the
risks associated with owning the asset. The lease will be for a period
substantially shorter than the likely life of the asset.
2. Finance leases
Under a finance lease, the lessee takes on most of the risks associated
with owning the asset. The lease will be for a period similar to the likely
life of the asset. It is shown in the statement of financial position as an
asset and a liability.
© IFE: 2019
6
Describe bank loans and loan facilities.
© IFE: 2019 

Bank loans
A bank loan is a form of medium-term borrowing where the full amount of the
loan is paid into the borrower’s account and the borrower undertakes to make
interest payments and capital repayments on the full amount of the loan.
The interest rate is usually variable. Bank loans are usually secured on the
borrower’s assets using a floating charge.
Loan facilities
A loan facility is a cross between an overdraft facility and a traditional bank loan.
The borrower can take out the loan in instalments, giving the bank a few days’
notice before each new one is taken out. Interest is only charged on the
amount outstanding and repayment schedules are flexible.
© IFE: 2019
7
Outline what is meant by a ‘syndicated’ loan.
© IFE: 2019 

Syndicated loans
A syndicated loan is a loan facility provided by a group of banks. Syndication

is typically used when the sums to be borrowed are larger than any one bank
would be happy to lend.
© IFE: 2019
8
List FIVE forms of short-term finance.
© IFE: 2019 

Five forms of short-term finance
1. Bank overdrafts
2. Trade credit
3. Factoring
4. Bills of exchange
5. Commercial paper
© IFE: 2019
9
Describe bank overdrafts.
© IFE: 2019 

Bank overdrafts
An overdraft is a form of short-term borrowing from a bank where the borrower

is granted a facility to draw money out of a current account such that it
becomes negative, down to an agreed limit.
The borrower pays interest only on the amount actually overdrawn. The
interest charged on an overdraft will usually be higher than on a loan of
equivalent amount.
Overdrafts made to companies are usually secured by a floating charge.
No explicit capital repayments are made but the bank can demand immediate
repayment of an overdraft with no notice.
© IFE: 2019
10
Describe trade credit.
© IFE: 2019 

Trade credit
Trade credit is an agreement between a company and one of its suppliers to

pay for goods or services after they have been supplied.
It is available from almost all suppliers to their business customers as part of the
supplier’s normal terms of business.
In most cases no explicit interest is charged. In many industries, trade credit

is so common that explicit discounts can be negotiated for ‘cash on delivery’.
© IFE: 2019
11
State an advantage and a disadvantage of a company using trade credit as

fully as possible.
© IFE: 2019 

Advantage and disadvantage of using trade credit fully
+ Trade credit facilities enable a company to obtain ‘free’ finance.
– (Over-)use of trade credit can damage a company’s relationships with

its suppliers.
© IFE: 2019
12
Distinguish between:
 non-recourse factoring
 recourse factoring.
© IFE: 2019 

Non-recourse factoring
Non-recourse factoring is where the supplier sells on its trade debts to a factor
in order to obtain cash payment of the accounts before their actual due date.
The factor takes over all responsibility for credit analysis of new accounts,
payment collection and credit losses.
Recourse factoring (or invoice discounting)
Recourse factoring only provides early payment of invoices. It is a loan which

is secured against the invoices, and has a value which automatically
fluctuates with the amount that the company sells.
Credit risk remains with the original supplier.
© IFE: 2019
13
Describe bills of exchange.
© IFE: 2019 

Bills of exchange
A bill of exchange is a promise by a company to pay the bearer a fixed sum of

money on a fixed date. The bill is ‘accepted’ or endorsed by an investment
bank and hence it is sometimes referred to as a two-name instrument. A
company might issue such a bill as payment for goods.
A bill of exchange is a tradeable instrument.
Where the endorser is an eligible bank, the bill is known as an eligible bill and
is a very secure investment due to the bank’s guarantee.
© IFE: 2019
14
Describe commercial paper.
© IFE: 2019 

Commercial paper
Commercial paper is a single-name form of short-term borrowing used by

large companies.
It comes in the form of bearer documents for large denominations which are
issued at a discount and redeemed at par.
Commercial paper is not listed on the Stock Exchange. However, companies

wishing to issue sterling commercial paper must meet certain minimum
standards. Issuing companies must:
 be listed on the London Stock Exchange
 issue a statement to confirm that they comply with Stock Exchange
requirements and that there have been no adverse changes in the
company’s circumstances since the last published accounts.
© IFE: 2019
Summary Card
Medium-term finance Cards 1 to 7
Short-term finance Cards 8 to 14
© IFE: 2019 

CB1
Chapter 7
CB1 Ch 7: Alternative sources of finance
1
Describe the meaning of the term shadow banks.
Give one benefit and one drawback of shadow banks for the economy.
© IFE: 2019 

Shadow banks
Shadow banks are non-bank financial institutions that convert short-term

liabilities to long-term assets outside the regulated banking system.
Unlike banks, shadow banks do not take deposits but instead borrow short
term funds in the money market and lend these over the longer term.
Since shadow banks are outside the banking regulatory system, they are not
subject to capital requirements and reserve requirements imposed on the
commercial banks. This means that they can offer higher returns to lenders.
However, they are not able to borrow from the central banks and are thus
more exposed and risky in an emergency.
© IFE: 2019
2
Describe the key features of project financing.
© IFE: 2019 

Key features of project financing
 The creation of a special purpose vehicle (SPV), which raises the

finance for the project. It is set up for the specific project, and
subcontracts construction and operating contracts. The shareholders of
the SPV are typically the sponsor companies that will be involved in the
work. Government participation is possible, which may be as a
shareholder in the SPV for large projects, or by providing guarantees
and permits in other projects.
 Raising non-recourse finance, meaning that the lenders to the SPV

have no recourse to any other contractors or operators directly. They
rely on the cashflows and assets of the project for their payments.
 This means that the finance raised is off the balance sheets of the
construction and operating companies. This prevents the debt from
increasing their gearing.
© IFE: 2019
3
Discuss the advantages and disadvantages of financing large projects using

project financing methods.
© IFE: 2019 

Advantages and disadvantages of project financing
From the government’s perspective, it means that the debt is raised by a

private entity, namely the SPV. The government does not have to borrow
directly. This may help protect its borrowing capacity.
For investors in the debt securities, a higher return is obtained to compensate

for the risk and illiquidity.
For investors, the construction phase will be risky, as there are no cashflows
generated from the asset being constructed.
The higher return offered on project finance is an additional cost for the
project. The overall cost of the project will therefore be higher than using
other financing methods.
The complexity of the financing structure means that administration costs are
higher, which will be passed down the line, making the project more
expensive.
© IFE: 2019
4
Describe the four main types of crowdfunding.
© IFE: 2019 

Crowdfunding
● Donation-based crowdfunding: In donating to a charity there are no

financial rewards and donors derive satisfaction from helping the
charitable cause.
● Pre-payment or reward-based crowdfunding: In return for giving money,
participants are rewarded by receiving a service or a product such as
concert tickets or a new computer game.
● Loan-based crowdfunding also known as ‘peer-to-peer lending’: Investors
receive interest on the money they lend and their capital is repaid over
time.
● Investment-based crowdfunding: Investors buy shares and benefit if the
business succeeds.
© IFE: 2019
5
Describe the meaning of microfinance.
© IFE: 2019 

Microfinance
No interest is paid on the microloan and the investor has the benefit of being
involved in initiating a venture.
Microloans are used for start-ups and small businesses and often have
generous repayment periods.
Charities involved in reducing poverty and promoting small scale start-ups in
the developing countries use microfinance to encourage investors to fund
small scale businesses.
Microloans are small loans that are usually easier and faster for the borrowers
to secure than the traditional loans.
© IFE: 2019
Summary Card
Shadow banks Card 1
Project financing Cards 2 to 3
Crowdfunding Card 4
Microfinance Card 5
© IFE: 2019 

CB1
Chapter 8
CB1 Ch 8: Use of derivatives
1
Define a future.
List the FOUR main categories of financial futures.
Explain how forwards differ from futures.
© IFE: 2019 

Futures
A futures contract is a standardised, exchange tradeable contract between

two parties to trade a specified asset on a set date in the future at a specified
price.
Financial futures
1. Bond
2. Short-term interest rate
3. Stock index
4. Currency
Forwards are similar to futures, but are individually negotiated between two
parties, whereas futures are standardised. Forwards are not traded on an
exchange.
© IFE: 2019
2
Describe the purpose of margin payments for futures and explain when and by
which party margin payments are made and received.
© IFE: 2019 

Margin
Margin payments act as a cushion against potential losses which the parties
may suffer from future adverse price movements.
 When the contract is first struck, initial margin is deposited with the
clearing house by both parties.
 Additional payments of variation margin may be required as the price of

the underlying asset moves. Variation margin will be positive for one
party and negative for the other.
 At expiry, the clearing house returns the net margin to both parties.
© IFE: 2019
3
Define an option.
Distinguish between the following option types:
 call
 put
 American
 European.
© IFE: 2019 

Options
An option gives an investor the right, but not the obligation, to buy or sell a
specified asset on a specified future date for a specified price.
A call option gives the right, but not the obligation, to buy a specified asset on
a set date in the future for a specified price.
A put option gives the right, but not the obligation, to sell a specified asset on
a set date in the future for a specified price.
An American style option is an option that can be exercised on any date

before its expiry.
A European style option is an option that can be exercised only at expiry.
© IFE: 2019
4
Explain why non-financial companies might use financial futures and options.
© IFE: 2019 

Use of financial futures and options by non-financial companies
A company can use financial futures to fix the value of its:

 assets and/or liabilities
 future receipts and/or payments.
This brings the advantage of certainty for the company. With hindsight, it may
be a good thing or a bad thing for the company, depending on how the price of
the underlying instrument changes.
Options allow a company to:

 protect itself against adverse price movements of the underlying asset
 still retain the ability to profit from favourable movements.
The price the company pays for this ‘no lose’ payout is the cost of buying the
option, ie the option premium.
© IFE: 2019
5
Describe:
 interest rate swaps
 currency swaps.
© IFE: 2019 

Swaps – descriptions
Interest rate swaps
 One party pays the other a regular series of fixed amounts for a certain
term.
 In exchange, the second party pays a series of variable amounts based
on the level of a short-term interest rate.
 Both sets of payments are in the same currency.
 There is no exchange of capital.
Currency swaps
 A fixed series of interest payments and a capital sum in one currency is

exchanged for a fixed series of interest payments and a capital sum in
another.
© IFE: 2019
6
State:
 the TWO kinds of risk faced by counterparties to a swap
 the TWO main uses of swaps by non-financial companies.
© IFE: 2019 

Swaps – risks and uses
Risks
1. Market risk
2. Credit risk
Uses
1. Risk management (by better matching of assets and liabilities)
2. Reducing the cost of debt (by exploiting comparative advantage)
© IFE: 2019
Summary Card
Futures Cards 1 & 2, 4
Options Cards 3 & 4
Swaps Cards 5 & 6
© IFE: 2019 

CB1
Chapter 9
CB1 Ch 9: Introduction to accounts
1
List the FOUR main users of financial statements.
List other users of the financial statements.
© IFE: 2019 

Users of financial statements
The main users are:

1. shareholders (both actual and potential)
2. creditors (both long-term and short-term)
3. employees
4. business contacts (customers and suppliers).
Other users are:

 the tax authorities (and other government agencies)
 competitors
 potential predators
 the management of the company
 the Stock Exchange
 stock analysts
 credit rating agencies.
© IFE: 2019
2
List the sources of regulation of UK financial statements.
© IFE: 2019 

Sources of regulation of UK financial statements
 International financial reporting standards

 National company law (specifically, the Companies Act in the UK)
 Other legislation
 Accounting principles, concepts and conventions
 Good practice by leading companies
 Stock Exchange requirements
The fact that there is a network of regulations and regulators can make the
preparation of financial statements a complicated undertaking.
© IFE: 2019
3
List the FIVE statutory requirements of the UK Companies Act.
© IFE: 2019 

Statutory requirements of the Companies Act
 A statement of financial position (balance sheet) showing the financial

position on the last day of the company’s financial year
 A statement of profit or loss (income statement) which forms part of the

statement of comprehensive income for the financial year
 Detailed disclosures which are normally presented as a series of notes

to the accounts
 A directors’ report
 An auditors’ report
Small companies have less onerous requirements.
© IFE: 2019
4
List the main contents of a directors’ report.
© IFE: 2019 

Contents of a directors’ report
 Detail about the company’s activities over the previous financial year,
and likely events in the coming year, including any major events or
deals that have happened since the end of the financial year
 A brief summary of the financial decisions that the directors have made,
including:
 the proposed dividend
 the amount of shareholders’ profits retained by the company
 charitable donations made by the company
 details of any of the company’s own shares that have been
purchased during the year
 Details of persons who were directors during the year, their
shareholdings and their other interests in the company
 For listed companies, additional information required by the Stock
Exchange such as a geographical analysis of turnover
© IFE: 2019
5
State the overriding requirement of financial statements.
© IFE: 2019 

The overriding requirement of financial statements
The overriding requirement of financial statements is that they provide a true

and fair view of the financial position of the company.
© IFE: 2019
6
Outline the arguments for and against a system of international financial

reporting standards.
© IFE: 2019 

Arguments FOR international financial reporting standards
 Variations between the way companies prepare accounts can be
eliminated
 Standards discussion process focuses attention on areas for debate
 Companies obliged to disclose more information than national laws
require
 Some flexibility is allowed in a way that legislation often does not allow
Arguments AGAINST international financial reporting standards
 Rules may not be appropriate to all companies in all circumstances
 Standard-setting may not be entirely objective
 Alternative treatments are allowed which negates the attempt to ensure
conformity
 Some standards are too general, while others are too detailed
© IFE: 2019
7
Explain the purpose of an auditors’ report.
© IFE: 2019 

Purpose of an auditors’ report
The fundamental purpose of the audit report is to add credibility to the

financial statements.
In the UK, every company (above a certain size) is required by the Companies
Act to appoint auditors. Auditors are appointed by the shareholders to report
to them on the financial and other reports prepared by the directors of the
company.
The auditors must comment on whether, in their opinion,

 the statement of financial position and statement of profit or loss have
been properly prepared in accordance with the Companies Act and
relevant accounting standards
 that the information in the Directors’ Report is consistent with the
financial statements
 the accounts give a true and fair view.
© IFE: 2019
8
List the contents of an auditors’ report.
© IFE: 2019 

Contents of an auditors’ report
1. A title, identifying the person or persons to whom the report is

addressed
2. An introductory paragraph identifying the financial statements audited
3. Separate sections, appropriately headed, dealing with:

(a) respective responsibilities of directors and auditors
(b) the basis of the auditors’ opinion
(c) the auditors’ opinion on the financial statements
4. The manuscript or printed signature of the auditors, with their address
5. The date of the auditors’ report
© IFE: 2019
9
List the FOUR possible qualifications or modification that a company’s

external auditor can make to the standard audit report where they are unable
to express an unqualified opinion that the accounts are true and fair.
© IFE: 2019 

Possible auditors’ opinions
There are four types of modified report:

1. emphasis of matter paragraphs
2. qualified opinion
3. disclaimer of opinion
4. adverse opinion.
© IFE: 2019
10
Describe briefly the four possible qualifications of opinion or report that

auditors can give.
© IFE: 2019 

Four possible qualifications of auditors’ opinion
Emphasis of matter paragraphs – If there is a significant uncertainty which has

been disclosed in the accounts, the auditor should point this out for emphasis.
Qualified opinion – issued where there is a restriction on the evidence that the
auditor can access, or where the auditor disagrees with the treatment of a
matter. The auditor is still able to express an opinion of the financial
statements ‘except for’ the disclosed problem.
Disclaimer of opinion – If the auditor is faced with such extreme uncertainty

that it is impossible to express an opinion, a disclaimer of opinion may be
issued.
Adverse opinion – This is issued where the auditor believes that the financial
statements are so misleading that they do not give a true and fair view.
© IFE: 2019
11
List ELEVEN accounting concepts.
© IFE: 2019 

Accounting concepts
1. money measurement
2. cost
3. matching
4. consistency
5. materiality
6. business entity
7. realisation
8. accruals
9. dual aspect
10. prudence
11. going concern
© IFE: 2019
12
Briefly describe the money measurement concept.
© IFE: 2019 

The money measurement concept
Accounting statements restrict themselves to matters which can be measured

objectively in money terms.
This simplifies accounting enormously.
It also means that a statement of financial position will rarely give even a
rough approximation of the value of the business because it will exclude such
items as the values of the company’s:
 customer base
 workforce
 brand names.
© IFE: 2019
13
Briefly describe the cost concept.
© IFE: 2019 

The cost concept
Non-current (or fixed) assets generally appear in the statement of financial

position at their original cost less depreciation to date, subject to a possible
impairment writedown.
This convention ignores changes in the purchasing power of money and can
produce different values for identical items but simplifies the task of
maintaining bookkeeping records because the original cost of an asset is
normally a straightforward matter to determine.
The cost concept is being gradually phased out in order to provide more
scope for realism in the financial statements. For example, tangible non-
current assets such as property, plant and equipment can be shown at their
fair value rather than their historical costs.
© IFE: 2019
14
Briefly describe the matching concept.
© IFE: 2019 

The matching concept
The matching concept is a mixture of the realisation concept (for income) and
the accruals concept (for expenses) and says that income and expenses
which relate to each other should be matched together and dealt with in the
same statement of profit or loss.
© IFE: 2019
15
Briefly describe the consistency concept.
© IFE: 2019 

The consistency concept
The figures published by the company should be comparable from one year to
the next. Accounting policies should not, therefore, be changed unless there
is a very good reason for doing so.
Any changes should be highlighted and their impact explained and the
numerical effect on the company’s results for the year should be shown.
© IFE: 2019
16
Briefly describe the materiality concept.
© IFE: 2019 

The materiality concept
Grouping – Financial statements can be made clearer by showing totals such

as ‘administrative expenses’ instead of listing every item which make up this
total.
Approximation – There is very little point in making minute adjustments which

have no real effect on the picture portrayed by the financial statements. So
approximations for certain costs might be reported.
What is, or is not, material however does depend to some extent on the
emphasis which the company will put on the relevant figures.
© IFE: 2019
17
Briefly describe the business entity concept.
© IFE: 2019 

The business entity concept
The affairs of the business are kept separate from those of its owners.
This is perfectly valid in the case of a limited company, which has its own legal
identity. It also applies to sole traders and partnerships where the business
does not have a separate legal form.
© IFE: 2019
18
Briefly describe the realisation concept.
© IFE: 2019 

The realisation concept
Income is recognised as and when it is earned; it is not necessary to wait until

the customer settles his or her bill.
This avoids the fluctuations in reported income which might arise if everything
was accounted for on a cash basis.
It can also create the impression that the business is performing well when, in
fact, it is in danger of running out of cash. A business which is expanding
might report income long before the related cash inflows.
© IFE: 2019
19
Briefly describe the accruals concept.
© IFE: 2019 

The accruals concept
Expenses are recognised as and when they are incurred, regardless of

whether or not the amount due has been paid.
This avoids the random allocation of costs to periods depending on whether

the bill happens to have been paid or not.
© IFE: 2019
20
Briefly describe the dual aspect concept.
© IFE: 2019 

The dual aspect concept
Every transaction or adjustment will affect two figures.
This concept forms the basis for the double-entry bookkeeping system.
© IFE: 2019
21
Briefly describe the concept of prudence.
© IFE: 2019 

Prudence
Financial statements should avoid presenting an unduly optimistic position.
The lowest reasonable figure should be stated for profit or for any of the
assets. The highest reasonable figure should be stated for any liabilities.
However, it is not permitted to include deliberate margins in the financial

statements by understating assets or revenues, or by overstating liabilities or
expenses. Prudence should only be applied in situations where there is
uncertainty.
© IFE: 2019
22
Briefly describe the going concern concept.
© IFE: 2019 

The going concern concept
The going concern concept means that the business will continue in
operational existence for the foreseeable future.
It is usually assumed that a business will continue indefinitely in its present

form.
Directors are required to report that the business is a going concern. If they are
in doubt, they should not prepare accounts on a going concern basis.
© IFE: 2019
23
Define relevant according to IAS 8.
© IFE: 2019 

IAS 8
In the absence of a specific rule to specify an appropriate accounting policy,

the company should select policies on the basis that they yield information
that is both relevant and reliable.
Information is relevant if it informs decisions taken by users of the financial

statements.
© IFE: 2019
24
Define reliable according to IAS 8.
© IFE: 2019 

IAS 8
Information is reliable if it has the following attributes:

 it provides a faithful representation of the entity’s financial position,
financial performance and cashflows
 it reflects the economic substance of transactions, other events and
conditions, and not merely their legal form
 it is neutral and free from bias
 it is prudent
 it is complete in all material respects.
There can sometimes be a conflict between relevance and reliability.
© IFE: 2019
Summary Card
Users of financial statements Card 1
Regulation Cards 2, 3, 5 and 6
Directors’ report Card 4
Auditors’ report Cards 7 to 10
Accounting concepts Cards 11 to 22
IAS 8 Cards 23 and 24
© IFE: 2019 

CB1
Chapter 10
CB1 Ch 10: The main accounts
1
Set out the main headings in a statement of financial position in a format that
complies with international accounting standards.
© IFE: 2019 

Format of the statement of financial position
ASSETS:
Non-current assets
Current assets
Total assets
EQUITY AND LIABILITIES:

Share capital
Other reserves
Retained earnings
Total equity
Non-current liabilities
Current liabilities
Total liabilities
Total equity and liabilities
© IFE: 2019
2
Distinguish between non-current (or fixed) and current assets.
© IFE: 2019 

Distinction between non-current and current assets
The distinction between non-current and current assets has more to do with
the motive behind their acquisition than their nature.
Non-current assets usually have long lives and are bought with the intention of
using them in the business. They may be tangible or intangible.
Current assets are cash and items which will be converted into cash in the
normal course of business, eg inventories (stocks) and trade receivables
(debtors).
© IFE: 2019
3
Describe intangible assets.
© IFE: 2019 

Intangible assets
Intangible assets are non-current assets that literally cannot be touched.
The most common type of intangible asset is goodwill, which arises when a
company buys another company for more than the value of share capital and
reserves in the statement of financial position of the target company. The
difference between the price paid and the value in the statement of financial
position is the goodwill.
Other possible intangible assets include:

 research and development costs
 concessions
 patents
 trade marks and brand names.
© IFE: 2019
4
Outline the component parts of the equity capital on the statement of financial
position.
© IFE: 2019 

Equity capital
The equity capital consists of:

 share capital (the nominal value of the shares issued)
 other reserves:
 share premium account (the amount raised above the nominal
value when the shares were issued)
 the revaluation reserve (the amount by which the non-current
assets have been increased in value since their original
purchase)
 the retained earnings (the amount of profit from the current and
previous years that is retained by the business).
© IFE: 2019
5
Describe the long-term provisions element of the non-current liabilities.
© IFE: 2019 

Long-term provisions
Long-term provisions differ from the long-term borrowings in that the actual
amounts and timing of payments are subject to some uncertainty.
However, they are liabilities and should be shown as such in the statement of
financial position.
For example, long-term provisions may include the estimated liabilities in

respect of deferred taxation and pension commitments.
© IFE: 2019
6
Explain the purpose of the statement of profit or loss.
© IFE: 2019 

Statement of profit or loss
The statement of profit or loss is one component of the statement of

comprehensive income. The statement of profit or loss is the section that
deals with revenues and expenses and calculates the profit after tax.
The statement of profit or loss provides an insight into a company’s trading

activities.
It compares the income generated from trading with the costs associated with
earning that income, the difference being the profit or loss for the year.
© IFE: 2019
7
Set out the main headings in a statement of profit or loss in a format that
complies with international accounting standards.
© IFE: 2019 

Statement of profit or loss format
Sales/Revenue
Cost of sales
Gross profit
Other operating income
Distribution costs
Administrative expenses
Operating profit
Finance income
Profit before tax and interest
Finance costs
Profit before tax
Tax expense
Profit for the year
© IFE: 2019
8
The profit figure is normally calculated in three stages. Define each of:
 gross profit
 operating profit
 profit before tax.
© IFE: 2019 

Profit figures
Gross profit is the difference between the selling price of the goods and
services which provide the basis for the company’s main trading activities and
the cost of sales.
Operating profit is usually defined as profit earned after all expenses except
finance costs (interest).
Profit before tax is the operating profit adjusted for financing (interest) costs
and finance income.
© IFE: 2019
9
State the reasons why a cashflow statement is needed.
© IFE: 2019 

Why a cashflow statement is needed
 To show movements in cash balances and so show liquidity
 To answer questions such as: why has the company’s overdraft

increased, despite the company making a profit?
 Because information about cash and liquidity is important (and, as cash

is different from profit, the statement of profit or loss alone does not
suffice)
 Because the cashflow statement is less subjective than the statement of

financial position and the statement of profit or loss
© IFE: 2019
10
Describe the THREE sections of the cashflow statement.
© IFE: 2019 

Sections of the cashflow statement
There are three sections to the cashflow statement:
1. cashflows from operating activities - starting from operating profit and

reconciling operating profit to cash, and deducting interest and tax paid
2. cashflows from investing activities - acquisitions and disposals of

long-term assets and other investments not included in cash
equivalents, plus investment income
3. cashflows from financing activities - changes in the size of equity

capital and borrowings, and deduction for dividends paid.
© IFE: 2019
11
Outline the format of the cashflow statement.
© IFE: 2019 

Cashflow statement format
Cashflows from operating activities

+ Cash generated from operations
– Interest paid
– Tax paid
Cashflows from investing activities
Cashflows from financing activities
Net (decrease) / increase in cash, cash equivalents and bank overdrafts

+ Cash, cash equivalents and bank overdrafts at beginning of the year
Cash, cash equivalents and bank overdrafts at end of the year
© IFE: 2019
12
Explain the purpose of the statement of changes in equity.
© IFE: 2019 

Statement of changes in equity
The statement of changes in equity summarises the changes in the capital

and reserves attributable to equity holders of the company over the
accounting period.
It therefore reconciles the amounts shown in the statement of financial

position at the start and end of the period.
It is a requirement of international accounting standards.
© IFE: 2019
13
Describe the contents of the notes to the accounts.
© IFE: 2019 

Notes to the accounts
The notes will cover:

 details of the accounting policies used in preparation of the financial
statements
 detailed analysis of totals in the statement of financial position
 detailed analysis of items in the statement of profit or loss
 details of significant events after the end of the accounting year.
In addition, companies will normally disclose, voluntarily, additional

information designed to help the readers of the accounts to gain a true and fair
view of the position of the company.
© IFE: 2019
Summary Card
Statement of financial position Cards 1 to 5
Statement of profit or loss Cards 6 to 8
Cashflow statement Cards 9 to 11
Statement of changes in equity Card 12
Notes to the accounts Card 13
© IFE: 2019 

CB1
Chapter 11
CB1 Ch 11: Depreciation and reserves
1
Define depreciation.
© IFE: 2019 

Depreciation
Depreciation is the measure of the wearing out, consumption or other

reduction in the useful economic life of a non-current (fixed) asset, whether
arising from:
 passage of time, or
 obsolescence through technological or market changes.
Depreciation adjustments are NOT attempts to reflect the market value of non-
current assets in the statement of financial position.
© IFE: 2019
2
Describe the straight-line basis of depreciation.
© IFE: 2019 

Straight-line depreciation
This method charges equal amounts every year as follows:
Cost - Estimated residual value

Estimated useful life
© IFE: 2019
3
Describe the reducing-balance method of depreciation.
© IFE: 2019 

Reducing-balance depreciation
This method charges a fixed % of ‘book value’ (ie cost less depreciation to
date) each year so that the whole cost is charged over the life of the asset.
The depreciation rate is calculated as follows:
n
Estimated residual value
1-
Cost
where n is the estimated useful life in years.
© IFE: 2019
4
List the THREE sources of equity capital.
© IFE: 2019 

Sources of equity capital
1. Sale of shares to shareholders
2. Adjustments, such as the revaluation of non-current assets
3. Retention of profit after tax
© IFE: 2019
5
Explain the purpose of the retained earnings reserve.
© IFE: 2019 

Retained earnings reserve
The retained earnings reserve is normally the aggregate amount of profits

earned during the lifetime of the company, less amounts paid out of profits for
tax and dividends.
Company law restricts dividends by restricting the maximum payout to the

retained earnings reserve in order to protect the interests of creditors.
© IFE: 2019
Summary Card
Depreciation – definitions Card 1
Straight-line depreciation Card 2
Reducing-balance depreciation Card 3
Sources of equity capital Card 4
Retained earnings reserve Card 5
© IFE: 2019 

CB1
Chapter 12
CB1 Ch 12: Constructing accounts
Summary Card
There are no normal cards for Chapter 12 as the chapter is about the process
of preparing financial statements rather than about more material to learn as
part of your revision.
Attempting as many questions as you can that require you to construct parts
of the accounts is essential and will put into practice the process described in
Chapter 12.
These two cards contain a few key ideas to remember when doing this.
© IFE: 2019 

The trial balance
All transactions are recorded during the year and entered twice in the books to
generate a table called a trial balance.
The trial balance can be presented in a number of ways:

1. as a simple list of numbers
2. as a list of positive and negative numbers adding to zero
3. as two columns (debits and credits) giving the same total.
The credit items consist of revenue (for the statement of profit or loss) and
liabilities and capital (for the statement of financial position).
The debit items consist of expenses (for the statement of profit or loss) and
assets (for the statement of financial position).
© IFE: 2019
CB1 Ch 12: Constructing accounts
Using the trial balance to produce the accounts
Every figure in the trial balance is used once in the preparation of either
the statement of profit or loss or the statement of financial position.
Read the notes below the trial balance carefully and work out the impact of
each note on the accounts. (In past exam questions, some of the more
awkward items to deal with have appeared in the notes below the trial
balance.)
Each note will normally have two effects on the accounts.
© IFE: 2019 

Awkward items
Make sure you practise these:

 depreciation (both methods)
 retained earnings
 inventories (stocks)
 adjustments for the accruals concept
 revaluation of properties
© IFE: 2019
CB1
Chapter 13
CB1 Ch 13: Group accounts and insurance company accounts
1
Explain what is meant by the terms:

 parent company
 subsidiary.
© IFE: 2019 

Parent company and subsidiaries
A parent company is a company that holds a controlling interest in another

company.
A subsidiary is a company that is controlled by a parent company.
© IFE: 2019
2
Explain why a parent company needs to publish consolidated financial

statements.
© IFE: 2019 

Need for consolidated financial statements
 They reflect the economic reality of the group’s existence as a single

economic entity.
 The shareholders are interested in the performance of the group as a

whole.
 The business activities of the group members are likely to be closely

related to one another, eg products, finance, management.
© IFE: 2019
3
If a subsidiary company is in danger of collapse, list the factors that make it

less or more likely to receive support from other group members.
© IFE: 2019 

Support between companies in a group
Less likely:
 since legally there is no obligation to support a subsidiary
 since contracts are made with individual companies, not the group
 if subsidiary is overseas
 if there are non-controlling (minority) shareholders
More likely:
 if there might be adverse publicity
 if any guarantees have been given by the parent company
© IFE: 2019
4
State THREE ways in which a parent company may obtain a controlling

interest in a subsidiary.
© IFE: 2019 

Controlling interest
1. Parent company owns > 50% of the voting rights
2. Parent company owns < 50% of the voting shares but still has the right
to appoint or remove directors holding a majority of the voting rights at
board meetings
3. Parent company has some other right to exercise a dominant influence

over the subsidiary (eg by holding a ‘golden share’)
© IFE: 2019
5
Outline the process of consolidation.
© IFE: 2019 

Consolidation
 Eliminate double counting. (Figures in the statements of the individual

group members that arise from relationships within the group must be
cancelled out.)
 Add figures. (Consolidation involves totalling the various items in the

statements of profit or loss and statements of financial position of the
individual group members.)
 Account for goodwill. (See separate card.)
 Account for any non-controlling interests. (See separate card.)
© IFE: 2019
6
Define goodwill and explain how it is treated in the consolidated accounts.
© IFE: 2019 

Goodwill
Goodwill is defined as the amount paid by the parent company in excess of

the nominal value of the shares and reserves acquired.
In theory, this is the amount which the parent is paying for such intangibles as
the reputation of the subsidiary, its customer base and its loyal and skilled
workforce.
IFRS 3 requires that all separately identifiable intangibles be recorded,

eg brand names, patents. Valuing these can be a complex matter in many
cases and will often require specialist advice. Only items capable of ‘money
measurement’ can be recorded.
© IFE: 2019
7
Define non-controlling interest and explain how it is treated in the consolidated

accounts.
© IFE: 2019 

Non-controlling interests
A non-controlling (or minority) interest is the value of the share capital and
reserves held by the subsidiary’s minority shareholders (as opposed to being
held by the parent company).
Given that the directors of the parent control all of the subsidiary’s assets, it
would not be appropriate to consolidate only that percentage that the parent
owns (which may be < 100%).
The non-controlling interest must be shown separately in the statement of

financial position, in the equity section, after the capital and reserves
attributable to equity holders.
© IFE: 2019
8
Define an associate (or associated company).
© IFE: 2019 

Associates
An associate (or associated company) is one which is not a subsidiary, but

which is subject to significant influence (but not control) by the parent.
There is normally a presumption that significant influence would arise if the

parent owned more than 20% of the associate’s voting rights.
© IFE: 2019
9
Outline how associates are treated on consolidation.
© IFE: 2019 

Consolidated accounts – associates
The parent’s share of the associate’s results are included in the consolidated
statement of profit or loss – regardless of whether it actually receives these by
way of dividend.
The consolidated statement of financial position includes the parent’s share of

the associate’s assets and liabilities.
The entries in both the statement of profit or loss and the statement of
financial position are single-line entries, which state the total amounts
attributable to associate companies.
Notes to the accounts should show how these totals are made up.
© IFE: 2019
10
State TWO features that complicate the preparation of insurance company

accounts.
© IFE: 2019 

Special features of insurance company accounts
1. The underlying contracts (liabilities) fall due outside the accounting

period and are uncertain in size.
2. Premature transfer of ‘profit’ to shareholders may endanger the financial

stability of the company and the ability to meet future liabilities.
© IFE: 2019
11
List the THREE possible component parts of an insurance company’s

statement of profit or loss.
© IFE: 2019 

Insurance company – statement of profit or loss
1. Technical account – general insurance business
2. Technical account – long-term insurance business
3. Non-technical account – which covers business activities of the

company that are neither general nor long-term insurance
A company may have only one of 1 and 2, depending on the types of

insurance products it sells.
© IFE: 2019
12
List the items that may appear in the assets and liabilities sections of an
insurance company’s statement of financial position that do not appear in a
typical trading company’s statement of financial position.
© IFE: 2019 

Insurance company – statement of financial position
Assets:
 Assets held to cover insurance liabilities
 Assets representing free reserves
 Reinsurers' share of technical provisions
 Trade receivables arising out of direct insurance operations
(eg amounts owed by policyholders or shareholders)
 Trade receivables arising out of reinsurance operations
 Prepayments (eg premiums paid in advance) and accrued income
(ie income that has accrued on a bond since the last coupon payment)
Liabilities:
 Fund for future appropriations
 Technical provisions (for both long-term and general insurance)
© IFE: 2019
Summary Card
Parent companies and subsidiaries Cards 1, 3 and 4
Consolidation – subsidiaries Cards 2 and 5 to 7
Associates Cards 8 and 9
Insurance company accounts Cards 10 to 12
© IFE: 2019 

CB1
Chapter 14
CB1 Ch 14: Interpretation of accounts
1
Accounting ratios fall into FIVE main groups, each looking at a different aspect
of a company and its performance. List these groups.
© IFE: 2019 

Groups of accounting ratios
1. Security of loan capital
2. Profitability
3. Liquidity
4. Business efficiency
5. Financial structure
© IFE: 2019
2
Define and describe the interest cover on an issue of loan capital.
© IFE: 2019 

Interest cover
profit on ordinary activities before interest and taxation

annual interest payments due on that issue of loan stock + all prior loan stock
The higher this ratio, the less likely it is that the company will be unable to
service the interest on its loans.
Rule of thumb: risky if the company cannot cover interest at least 3 or 4 times
© IFE: 2019
3
Describe interest priority percentages.
© IFE: 2019 

Interest priority percentages
Interest priority percentages show the slice of profit on ordinary activities

before interest and tax which covers the annual interest payments due on
each issue of loan capital.
For each issue of loan capital there will be a lower and upper interest priority
percentile.
If a company has, say, given some lenders a fixed charge over specific assets
then these loans will be repaid before loans with floating charges. Unsecured
loans will be repaid after these.
This ranking will be relevant to a lender who has to decide whether the other
loans that the company has taken out will affect the risk associated with a
particular loan stock.
© IFE: 2019
4
Define and describe the asset cover on an issue of loan capital.
© IFE: 2019 

Asset cover
total assets - current liabilities - intangible assets

loan capital + prior ranking debt
This will usually represent a conservative estimate of the amount of money

available to meet the loan stockholders’ demands for repayment of the capital
if the company were to wind up.
Rule of thumb: high risk if asset cover < 2 or 2.5
Main limitation: value shown in the statement of financial position for assets
might not reflect their realisable market value if the company is wound up.
© IFE: 2019
5
Describe asset priority percentages.
© IFE: 2019 

Asset priority percentages
Asset priority percentages show the slice of total assets less current liabilities
less intangible assets which is available to cover the nominal value of each
issue of loan stock.
For each issue of loan stock there will be a lower and upper percentile.
© IFE: 2019
6
Explain what is meant by gearing.
© IFE: 2019 

Gearing
Gearing refers to the relative proportions of long-term debt and equity finance
in a company. High gearing means that the company has a high proportion of
debt financing.
Measures of gearing include:

 asset gearing
 income gearing.
© IFE: 2019
7
Define asset (or capital) gearing.
© IFE: 2019 

Asset (or capital) gearing
borrowings or borrowings
equity borrowings + equity
Borrowings usually includes all forms of long-term debt.
Equity means the value of the ordinary shares shown on their statement of
financial position. It is normal to deduct the amount of any intangible assets.
Preference shares can be treated as either borrowings (usual) or as equity.
Rule of thumb: high risk if gearing > 40% (second formula)
The first definition is usually used in CAPM, the second in calculating WACC.
© IFE: 2019
8
Define the shareholders’ equity ratio.
© IFE: 2019 

Shareholders’ equity ratio
shareholders' equity - intangibles

total assets - current liabilities - intangibles
The higher this ratio, the stronger the financial position of the organisation.
© IFE: 2019
9
Define income gearing.
© IFE: 2019 

Income gearing
interest on borrowings
profit on ordinary activities before interest and tax
Interest on borrowings will usually include all forms of interest payable on debt
(ie on loan capital, and on overdrafts).
Treatment of preference shares varies – if treated as borrowings, preference

share dividends should be grossed up at the company’s rate of corporation
tax.
© IFE: 2019
10
Define and describe earnings per share (EPS).
© IFE: 2019 

Earnings per share (EPS)
earnings on ordinary activities

number of issued ordinary shares
Businesses whose shares are publicly traded are required to disclose two
versions:
 basic EPS – reflecting number of shares currently in issue
 diluted EPS – reflecting all dilutive potential shares, eg those under
convertibles or share option schemes.
EPS can be based on either historical or prospective earnings.
Comparing EPS values can be difficult because the number of shares is

arbitrary.
© IFE: 2019
11
Define price earnings ratio (PER) and explain the significance of a company
having a high PER relative to other similar companies.
© IFE: 2019 

Price earnings ratio (PER or P/E ratio)
market price of an ordinary share

earnings per share
A high PER relative to other similar companies may mean:

 the market believes that the company is a relatively low risk investment
 the market believes that the earnings will grow rapidly in the future
 the share is overvalued
 earnings are unusually low this year.
© IFE: 2019
12
Define dividend yield and explain the significance of a company having a low
dividend yield relative to other similar companies.
© IFE: 2019 

Dividend yield
dividends per share

market price of an ordinary share
A low dividend yield relative to other similar companies may mean:

 the market believes that the dividends will grow rapidly in the future
 the share is overvalued.
© IFE: 2019
13
Define and describe dividend cover.
© IFE: 2019 

Dividend cover
earnings per share

dividends per share
A company with a high level of dividend cover has more scope to increase
dividends in the future. So, for a given dividend yield on a share, a high
dividend cover figure suggests better value for money than a share with low
dividend cover.
Inverse of this is the payout ratio.
© IFE: 2019
14
State an expression relating:

 PER
 dividend yield
 dividend cover.
© IFE: 2019 

Relating PER, dividend yield and dividend cover
market price dividends per share dividends per share

¥ =
EPS market price EPS
or
1
PER ¥ dividend yield =
dividend cover
© IFE: 2019
15
Define EBITDA and explain why some analysts look at EBITDA in addition to
operating profit.
© IFE: 2019 

EBITDA
EBITDA is Earnings Before:

 Interest
 Taxation
 Depreciation
 Amortisation.
Some analysts look at EBITDA as they feel that depreciation and amortisation
can be misleading in the statement of profit or loss because they are
discretionary / subjective. Also, tax is out of the company’s control and
interest is affected by the gearing / financing decision.
© IFE: 2019
16
Define net asset value per share (NAV) and describe how it is used.
© IFE: 2019 

Net asset value (NAV) per share
ordinary shareholders' equity - intangible assets

number of issued ordinary shares
NAV per share shows the value on the statement of financial position of the
tangible assets backing each share, net of all liabilities.
It is approximately what the ordinary shareholders would receive for each

share they hold if the company was immediately wound up.
It is often compared with the share price to assess whether shares are
undervalued or overvalued.
The main problem with NAV per share is that the values on the statement of
financial position don’t necessarily reflect the market or true values of the
assets.
© IFE: 2019
17
Give the TWO main definitions of return on capital employed.
© IFE: 2019 

Return on capital employed (ROCE)
profit before tax and interest

×100
share capital + reserves + long-term debt
and
profit before tax

×100
share capital + reserves
Consistency between denominator and numerator is crucial. If you remove

debt from the denominator, you must remove interest on that debt from the
numerator.
© IFE: 2019
18
State how ROCE can be broken down into TWO secondary ratios.
© IFE: 2019 

Breakdown of ROCE
1. Asset utilisation ratio – reflecting the intensity with which assets are
employed
revenue (turnover)
share capital + reserves + long-term debt
2. Profit margin (or return on sales ratio) – an attempt to look at profit per
unit of sales
profit before tax and interest

revenue (turnover)
Profit margin often is x100, ie expressed as %.
© IFE: 2019
19
Suggest SIX reasons why a firm may have a low profit margin compared with
other firms in the industry.
© IFE: 2019 

Profit margin
Low margins relative to other firms in the industry may indicate:

1. a more down-market product range
2. a ‘low margin, high volume’ marketing strategy
3. an attempt to increase market share
4. poor management / excessive costs
5. temporarily low profits and/or high costs (eg as a new product is
launched or production facilities are modernised)
6. subnormal profits are being made, so that the firm will exit the industry
in the long run.
© IFE: 2019
20
Define and describe current ratio.
© IFE: 2019 

Current ratio
current assets
current liabilities
A low ratio may indicate problems paying creditors.
A high ratio may indicate that too much cash is tied up in unproductive short-
term assets, eg cash in the bank.
Rule of thumb: 2x is optimal (but this varies between industries)
© IFE: 2019
21
Define quick ratio.
© IFE: 2019 

Quick ratio
current assets - inventories

current liabilities
Also known as acid test or liquidity ratio.
Rule of thumb: 1x is optimal (but this varies between industries)
It’s called the quick ratio, not because it’s quick to calculate, but because it
only recognises assets that could be reliably and quickly turned into cash.
© IFE: 2019
22
Define and describe inventory turnover period.
© IFE: 2019 

Inventory turnover period
inventories
×365
cost of sales
The ratio attempts to show how long inventory is held for on average.
An inventory turnover period that is less rapid (ie higher) than other
companies in the same industry might indicate an inefficiently large inventory
holding.
An increasing period might indicate that sales were slowing down resulting in
stockpiling of unsold goods.
Rule of thumb: there isn’t one – varies too much between businesses
© IFE: 2019
23
Define and describe trade receivables turnover period.
© IFE: 2019 

Trade receivables turnover period
trade receivables
×365
credit sales
Better for this period to be low. Important to compare this period with the
length of the credit period usually extended to customers.
However, it can be difficult to press for speedier payment as doing so could

damage the company’s relationship with its customers.
If the company sells goods for cash and for credit then it is important to divide
the trade receivables figure by credit sales only.
If not, or if split of sales is not available, can divide by total sales (although the
period will then be distorted).
© IFE: 2019
24
Define and describe payables turnover period.
© IFE: 2019 

Payables turnover period
trade payables
×365
credit purchases
A higher value is usually better. However, it is important to compare the figure

with the credit period usually granted by the company’s suppliers.
It can be difficult to calculate this ratio in the real world because companies do
not disclose their purchases figures.
In this case, it is possible to obtain a crude estimate by dividing by cost of

sales.
© IFE: 2019
25
Explain how the efficiency ratios would be modified if monthly accounts are
given.
© IFE: 2019 

Modification of efficiency ratios
The efficiency ratios in these cards assume accounts are annual and hence
include a ‘ ¥ 365 ’ factor.
When examining monthly accounts (eg internal management accounts), the

ratios are adjusted for the different day count accordingly, ie the ‘ ¥ 365 ’ is
replace by ‘ ¥ 365 / 12 ’ or ‘ ¥ 31’ or the exact number of days in the month given,
eg ‘ ¥ 28 ’ for February.
© IFE: 2019
Summary Card
Overview of ratios Card 1
Security of loan capital ratios Cards 2 to 9
Shareholder ratios Cards 10 to 16
Profitability ratios Cards 17 to 19
Liquidity ratios Cards 20 and 21
Business efficiency ratios Cards 22 to 25
© IFE: 2019 

CB1
Chapter 15
CB1 Ch 15: Limitations of accounts and alternative reporting
1
‘Historical cost accounting tends to distort profits during times of inflation.’
State FOUR possible reasons why this statement is true.
© IFE: 2019 

Shortcomings of historical cost accounting
Reasons historical cost accounting tends to distort profits during times of

inflation:
1. Cost of sales is understated (because of the time lag between the

purchase of an item of inventory and its eventual sale).
2. Depreciation is understated (calculated using the historical cost of the

assets).
3. Net interest payments (for companies that pay out less interest than
they receive).
4. Profits and asset values may be increasing in money terms, but hard to
identify how much is a real increase.
© IFE: 2019
2
State FOUR examples of subjectivity in determining figures in the accounts.
© IFE: 2019 

Subjectivity in accounts
1. Value of inventories
2. Depreciation
3. Revaluation of assets
4. Intangible assets
© IFE: 2019
3
List FIVE features of the figures in the accounts that may make them
inappropriate for a particular user.
© IFE: 2019 

Appropriateness of the accounts figures used
1. Going concern (not wind-up)
2. Face values of trade receivables and payables, ie debtors and creditors

(not present values)
3. Depreciated historical cost of assets (not economic value)
4. Estimates (not accurate)
5. End-year values (not average values)
© IFE: 2019
4
List FOUR possible differences between two companies’ accounts that would
make comparisons between the companies difficult.
© IFE: 2019 

Comparisons between companies
1. Approaches to subjective figures, eg depreciation
2. Creative accounting
3. Formats of accounts
4. Level of aggregation
© IFE: 2019
5
State FOUR limitations of ratio analysis.
© IFE: 2019 

Limitations of ratio analysis
1. Diverts attention from the figures and the accounting statements

themselves
2. Comparisons may not be appropriate
3. Different industries have peculiarities which make the values of many

ratios industry-specific, eg normal duration of trade credit
4. Creative accounting
© IFE: 2019
6
List THREE reasons why some figures in the accounts may not be accurate.
© IFE: 2019 

Accuracy of figures
1. Out of date by the time published
2. Window dressing
3. Use for forecasting is problematic (as no real indication of sustainability

or future company plans)
© IFE: 2019
7
List EIGHT ways in which figures in the accounts could be manipulated.
© IFE: 2019 

Manipulation of figures in the accounts
1. Inappropriate depreciation of tangible assets

2. Inappropriate writing off of intangible assets
3. Inappropriate valuation of inventories
4. Inappropriate valuation of future liabilities (including pension provisions)
5. Unwarranted revaluation of tangible assets
6. Creating intangible assets of questionable true worth
7. Omitting contingent liabilities
8. Prebooking of anticipated sales revenues
Such manipulation of reported figures may be illegal and certainly would be

contrary to the professional standards expected of those preparing accounts.
© IFE: 2019
Summary Card
Historical cost accounting Card 1
Subjectivity Card 2
Inappropriate figures Card 3
Difficulties of comparisons Card 4
Limitations of ratio analysis Card 5
Inaccurate figures Card 6
Manipulation Card 7
© IFE: 2019 

CB1
Chapter 16
CB1 Ch 16: Evaluation of working capital
1
Define ‘working capital’.
State SIX events that could arise if a company has insufficient liquidity (liquid
resources).
© IFE: 2019 

Working capital
Current assets  current liabilities
The following can occur when a company has insufficient liquidity:
1. deterioration of credit rating
2. forced sale of assets
3. bankruptcy
4. liquidation
5. workers on strike if salaries are not paid
6. suppliers may stop providing raw materials if they are not paid.
© IFE: 2019
2
Give a formula for the term ‘working capital cycle’.
Describe in words what it represents.
© IFE: 2019 

Working capital cycle
Inventory turnover period + trade receivables turnover period

 trade payables turnover period.
It represents the period of time between a company’s cash being transferred

out to pay for materials and the cash being recouped when a customer pays
for goods. A shorter cycle means that cash resources are not depleted for
long as a result of the company’s production process and will help reduce the
need for liquid resources or external funding.
The key to successfully managing working capital is to keep the inventory

turnover and trade receivables turnover as rapid as possible while delaying
payment so that the trade payables turnover is as long as possible (although
this may strain relations with suppliers).
© IFE: 2019
3
List SIX reasons why a business might hold more inventory that it needs.
© IFE: 2019 

Holding excessive inventory
1. It may be difficult to predict with certainty exactly when the materials will
be required
2. Running out of inventory can result in lost sales which is seen as a

greater threat
3. The lead time to arrange delivery of inventory might be long and

uncertain. ‘Just-in-time’ (JIT) methods may not be available.
4. The firm might be expecting the cost of the materials to rise
5. Short-term funds might be readily available to buy the inventory
6. Ordering costs, delivery charges and administration involved in buying

more frequent, smaller amounts of inventory might be high
© IFE: 2019
4
List FOUR issues that a company will need to establish about its customers in
order to efficiently manage its trade receivables.
© IFE: 2019 

Comparisons between companies
1. Customer’s creditworthiness (eg do they have a high bank balance?)
2. Terms on which credit was granted to the customer
3. Methods of payment collection
4. Systems available for monitoring receivables and collections.
© IFE: 2019
5
State TWO disadvantages for a company that offers its customers a

discounted price for early or prompt payment.
© IFE: 2019 

Disadvantages of discount for early payment
1. The discount is expensive, being a small percentage over a very short

period of time.
2. The customer may accept the discount but still pay late.
© IFE: 2019
6
Calculate the benefit to a company that delays a £400,000 supplier payment

for 8 days, when the cost of short-term finance is 4% pa.
© IFE: 2019 

Benefit of delaying payment
The cost is given by the formula:
cost of finance (pa)

(value of goods)  (number of daysdeferred ) 
365
4%
£400k  8   £351
365
© IFE: 2019
7
A supplier offers a discount of 2% if a customer pays within 30 days. All

customers must pay the bill before day 60.
Calculate the cost for a company that chooses to ignore the discount and pays
on day 60.
Comment on the logic of a company that chooses to ignore the discount but
pays on day 35.
© IFE: 2019 

Cost of trade credit
The costs will be calculated using the formula:
 365 
 
 discount  payment day  discount period 
cost of trade credit   1   -1
 1  discount 
 365 
 0.02  6030 
 1    1  27.9%
 1  0.02 
A company choosing to ignore the discount but not wait as long as possible is
increasing the cost to itself.
© IFE: 2019
8
Describe FOUR methods that can be used to enable a company to raise

short-term finance to finance a purchase.
© IFE: 2019 

Raising short-term finance
1. Short-term single bank loan: This will typically be for less than 3 months.
2. Line of credit: This is a facility whereby the company can borrow up to a

limit, based on a rate of interest that will be linked to LIBOR (plus a
margin) at the time. The line of credit may be committed by the bank, for
which there is a fee payable, or it may be assessed at the time of the
loan. The line of credit typically expires after one year.
3. Secured loan: the loan is secured on the inventory or account receivable.
4. Factoring: the company may borrow against certain existing customer

invoices, either on a recourse or on a non-recourse basis.
© IFE: 2019
9
A company has been offered a loan from a bank for £5m, for a period of
6 months, and at an annual interest rate of 4%. There is an arrangement fee
of 0.25% pa, and both the arrangement fee and the interest are deducted from
the loan at the start of the period.
Calculate the financing cost both as a rate over the 6-month period and as an
annual amount.
© IFE: 2019 

Financing cost
The financing cost is given by the formula:
interest  commitment fee

usable funds
where usable funds  £5m  £100k  6.25k  £4.894m
£5m  4%  1 + £5m  0.25%  1

2 2  2.17%
£4.894m
An annualised amount is simply double the rate: 4.34% pa.
© IFE: 2019
10
If a company wishes to maintain its dividend despite not having sufficient cash
resources, list THREE options for raising the cash required.
Discuss the merits of this proposal.
© IFE: 2019 

Raising the cash to pay the dividend
1. Sale of assets
2. Borrowing (eg loan stock or large bank loan)
3. Sale of shares (ie a rights issue)
If the cash problem is a one-off, then the proposal has its merits as it prevents
the dividend having to be cut. If the problem is longer-term, then it can be
viewed as irresponsible because it is unsustainable.
© IFE: 2019
Summary Card
Working capital Cards 1 and 2
Managing liquidity Cards 3 to 7
Short-term finance Cards 8 and 9
Dividend financing Card 10
© IFE: 2019 

CB1
Chapter 17
CB1 Ch 17: Constructing management information
1
Define the term ‘forecast’ in the context of company management information.
List the advantages and disadvantages of using statistical techniques to carry

out forecasts.
© IFE: 2019 

Forecasts
A prediction of future events and their quantification for planning purposes.
Advantages of statistical techniques:
 They are relatively easy to do, usually involving regression or simple

statistical techniques.
 They can be improved to take seasonal factors into account.
 Correlations between variables can be incorporated into the model to

improve reliability.
Disadvantages of statistical techniques:
 Forecasts are usually short-term and are often uncertain.
 Past trends are assumed to continue, leading to mis-interpretation.
© IFE: 2019
2
Describe the advantages and disadvantages of intuitive and judgement

techniques for carrying out forecasts.
© IFE: 2019 

Intuitive vs judgement techniques
Advantages of judgement based techniques of forecasting:
 Gathering the views and opinions of experts can give important insights
into the way things are likely to develop in the industry.
 Expert views should be better informed than those of other individuals.
 Certain experts may be in a position to influence the future, and so their

views are more likely to be correct.
Disadvantages of judgement based methods of forecasting:
 These methods can be much more complex, perhaps involving an

iterative process of gathering and disseminating views and opinions
within a group of experts.
© IFE: 2019
3
Define the following terms in the context of company management

information:
 budget
 variance
 budget stretch
 top down / bottom up
 planning horizons.
© IFE: 2019 

Definitions
A budget is a plan expressed in money. It is prepared and approved prior to

the budget period and may show income, expenditure and the capital to be
employed.
Variances refer to the differences between the actual outcome versus budget.
Budget stretch is the amount of slack or freedom that managers are given
around their budget.
A top-down method of budgeting begins with senior management setting

overall targets for the business which are then passed down to be distributed
and allocated to the smaller business units. A bottom-up approach begins
with junior managers setting their targets, which are then aggregated as they
pass up the organisation to create an overall budget for the business.
Planning horizons are the time periods over which budgets are planned.
Businesses often prepare more than one budget, including a long-term budget
and a short-term budget.
© IFE: 2019
4
Describe the FIVE stages of the budget process.
© IFE: 2019 

Five stages of the budget process:
1. Identify the limiting factor. This will often be the amount of sales that
the company can generate, but may be other things, such as the
amount of the product that it can manufacture.
2. Decide how the limiting factor will be managed (eg aim for 90% of
maximum production).
3. Set other operational budgets in a logical sequence.
4. Combine the budgets to find the overall operational budget for the year
(or other planning horizon). If this is not satisfactory, revisit the key
decisions that have been made along the way.
5. Implement the budget, involving communicating to divisional managers,

and monitoring variances from budget.
This makes the acronym CLIMB (Combine, Limiting factor, Implement,

Manage, other operational Budgets), but not in the correct order!
© IFE: 2019
5
List TWO advantages of a budgeting approach to business management.
© IFE: 2019 

Advantages of a budgeting approach:
1. They allow an element of management control over all levels of the

operation. Variances can be reported and managed.
2. They allow businesses to react quickly to changes in the business

environment.
© IFE: 2019
6
List THREE disadvantages of a budgeting approach to business

management.
© IFE: 2019 

Disadvantages of a budgeting approach:
1. Budgets can lead to incremental thinking.
2. They can incentivise senior managers to set unrealistic budgets for

business divisions, which can be demotivational. Alternatively they can
encourage junior managers to communicate easily-achievable targets to
their senior in order to facilitate a larger bonus.
3. Managers may take action solely due to the budget target. For example,
they could stop making sales once their budget has been reached to
avoid next year’s target being raised. Or they could increase spending at
the end of the year to ensure that unspent budget is not removed in the
following year.
© IFE: 2019
7
Describe the concepts of ‘zero based budgeting’ (ZBB) and ‘beyond

budgeting’ (BB).
© IFE: 2019 

Zero-based budgeting and Beyond budgeting
ZBB involves starting each budgeting round with a blank sheet. Every item of
spending needs to be justified from scratch without reference to last year’s
spending.
It forces managers to consider whether each item of spending is justified on a

year by year basis, but can be very time consuming.
BB does not try to put targets on spending and revenue at all, but measures
each divisional manager based on performance of the division (eg the
division’s return on capital, or profit growth).
This sets each manager in competition with the other managers and gives a
great deal of freedom. But it can involve an element of risk and lack of
control.
© IFE: 2019
Summary Card
Forecasts Cards 1 and 2
Budgeting Cards 3 to 7
© IFE: 2019 

CB1
Chapter 18
CB1 Ch 18: Growth and restructuring of companies
1
List THREE reasons why growing a business can lead to greater profits.
© IFE: 2019 

Why growing a business can lead to greater profits
1. The business can obtain economies of scale; lower unit costs when
buying in bulk, better credit terms, and investing in larger and more
efficient machinery
2. Increasing market share and market power
3. Expansion opportunities into new and growing markets
© IFE: 2019
2
List SEVEN reasons why growth can lead to greater business security.
© IFE: 2019 

Growth and business security
Growth can increase business security because:

1. Costs of transaction may be lower
2. Obtain more business from customers because of its size, or achieve
more secure relationships with suppliers
3. Diversification benefits exist (when one division is struggling, others are
holding steady)
4. Barriers to entry for new markets can be overcome
5. Uncertainty is reduced for planning purposes
6. Takeover from a competitor is more difficult
7. Threat posed to other businesses by the company is greater.
(Acronym: COD BUTT)
© IFE: 2019
3
List FOUR reasons why growing a business can lead to better motivation for
managers and employees.
© IFE: 2019 

Business growth and motivation
Motivation of managers and employees can be improved because:
1. there is increased prestige, power and salary for those working in a larger
organisation
2. employment risk (ie the risk of being made redundant) is decreased
3. staff morale can be improved
4. more able, ambitious and productive staff can be attracted.
© IFE: 2019
4
Describe FIVE reasons why a company’s growth may be constrained.
© IFE: 2019 

Reasons why growth may be constrained:
1. Growth will probably require finance, and this might be difficult to raise.
2. In the short term, growth may mean that the dividend may be cut or
held down. This can lead to a fall in the share price and perhaps a
takeover bid.
3. The managers of the company may not have the expertise to run a
larger company. The owners may also not want to lose control by
issuing shares for expansion.
4. The workforce may not be able to cope with the expansion if it happens
rapidly.
5. Monopoly restrictions may limit takeover strategies.
© IFE: 2019
5
List THREE reasons why internal growth may be preferred.
© IFE: 2019 

Reasons why internal growth may be preferred
1. The management retain control over the business
2. The culture of the business remains unaffected by alien practices
3. It avoids the risk of dealing with firms that may have more dubious
business ethics and practices
An additional point might be that it avoids the risk of government intervention

to avoid monopolies.
© IFE: 2019
6
List FOUR reasons why external growth may be preferred.
© IFE: 2019 

Reasons why external growth may be preferred
1. It is easier and quicker, particularly when expanding overseas
2. An opportunity to acquire assets or experience
3. It creates the opportunity to share the burden and the risk of the
expansion with another company
4. There is an opportunity to spend spare cash on a mature company
© IFE: 2019
7
List the THREE main categories of internal or external expansion.
© IFE: 2019 

Main categories of internal or external expansion
Horizontal: this involves expanding into a business area that is at the same
stage of the production process. It may for example involve buying a
company in the same industry.
Vertical: this involves developing new operations at different stages of the

production process or buying a company in a different stage of the process.
Conglomerate: this involves diversifying into a completely different business

area.
© IFE: 2019
8
List FIVE areas that would be considered when a company is investigating a

potential takeover target.
© IFE: 2019 

Investigating a potential target company
The five areas that would be investigated are:
1. The resources that are being acquired in terms of raw materials,

equipment, expertise etc
2. The costs that can be saved through the acquisition (including tax costs)
3. Additional market power achieved
4. Level of enhanced security for the larger firm
5. The compatibility of management culture, management style and

remuneration packages.
© IFE: 2019
9
Describe the SEVEN steps involved in the acquisition process.
© IFE: 2019 

The acquisition process
1. Check government policy and other relevant regulations

2. Obtain shareholder approval for purchasing the target’s shares
3. Arrange the raising of the finance (usually by raising equity or raising
debt)
4. Determine the method of payment for the target’s shares (eg give cash,
or exchange for shares in the acquiring company)
5. Approach the Board of the target company and communicate the offer
6. Discuss at Board level, and carry out due diligence until a final deal can
be agreed and voted on by target shareholders
7. If discussions fall through, decide whether to walk away or to make an
offer directly to target shareholders through the stock exchange
© IFE: 2019
10
Describe the TWO main ways that a leveraged buyout (LBO) differs from a
normal acquisition.
List the THREE main reasons why LBOs may result in higher profits.
© IFE: 2019 

Leveraged buyouts
A LBO differs from a normal acquisition because:

1. the funds used for acquisition usually involve a small amount of equity
(typically from a private equity firm or the management of the company)
and a great deal of debt
2. after the acquisition, the shares of the LBO are removed from the public
markets and the company becomes a private company.
The main reasons why LBOs result in higher profits are:

1. assets that are not needed are sold off
2. there is a tax shield on the high amount of debt finance
3. the new management reduce expenses and (unnecessary) capital
expenditure.
© IFE: 2019
Summary Card
Benefits of growth Cards 1 to 4
Types of acquisition Cards 4 to 7
Process of acquisition Cards 8 and 9
Leveraged buyouts Card 10
© IFE: 2019 

CB1
Chapter 19
CB1 Ch 19: WACC
1
Define the weighted average cost of capital (WACC).
© IFE: 2019 

WACC
Ê Market value of debt ¥ net cost of debt + ˆ

ÁË Market value of equity ¥ cost of equity ˜¯
WACC =
Market value of debt + equity
Note the definition uses market values rather than book values.
Note the cost of equity is the total return that is expected by individuals who
invest in the shares, not simply the dividend yield.
© IFE: 2019
CB1 Ch 19: WACC
2
State Modigliani and Miller’s irrelevance propositions.
© IFE: 2019 

Modigliani and Miller’s irrelevance propositions
First irrelevance proposition:
The market value of any firm is independent of its capital structure.
Second irrelevance proposition:
The expected rate of return on the common stock of a leveraged firm

increases in proportion to the debt-equity ratio, expressed in market
values.
or, equivalently:
The expected rate of return on the ordinary shares of a geared firm

increases in proportion to the debt-equity ratio, expressed in market
values.
© IFE: 2019
CB1 Ch 19: WACC
3
State THREE ways in which the strict Modigliani and Miller assumptions do
not hold in practice in the capital markets.
© IFE: 2019 

Relaxing the Modigliani and Miller assumptions
1. Tax – interest payments on corporate debt are tax deductible making

debt finance more attractive than equity finance.
2. Different borrowing availability and rates – companies have more

access to capital and can borrow at lower rates of interest than
individuals and different companies can borrow at different rates.
3. Restricted debt capacity – increased debt cannot be raised at the same

cost. Typically the rate of return required by debt holders increases as
the gearing ratio increases.
© IFE: 2019
CB1 Ch 19: WACC
4
Define:
 specific risk
 systematic risk.
© IFE: 2019 

Specific and systematic risks
Specific risk is risk that is specific to the return on investment in individual

shares or an individual project. It can be eliminated by diversification.
Systematic risk or market risk cannot be diversified away. It reflects the

variation in the return on investment in an individual share compared to the
return on investment in the market as a whole (a portfolio of shares). In the
case of projects, it reflects the variation in the return from the individual project
compared to the return on investment in a portfolio of projects.
© IFE: 2019
CB1 Ch 19: WACC
5
List SIX sources of systematic risk
© IFE: 2019 

Sources of systematic risk
1. Freak events
2. Interest rates
3. Tax
4. Business or trade cycle
5. Inflation
6. Currency
(These are the ones mentioned in the Core Reading in this chapter, but this
list is not exhaustive and you may have thought of others. The list can be
recalled using the acronym FIT BIC)
© IFE: 2019
CB1 Ch 19: WACC
6
Describe the beta ( b ) of a share.
© IFE: 2019 

Beta ( b )
The beta can be regarded as a measure of the systematic risk associated with
a particular share.
s im si
bi = or b i = rim
2
sm sm
2
where s m is the variance of return on investment in the market index, s im is
the covariance between the individual stock’s return and that of the market
and rim is the correlation coefficient between the individual company’s stock
return and that of the market.
b > 1 a share that amplifies the return of the whole market

0 < b < 1 a share with a return more stable than the market as a whole
b < 0 a share with a counter cyclical return (offsetting the overall market)
© IFE: 2019
CB1 Ch 19: WACC
7
Give a formula for:

 the cost of the equity market as a whole
 the cost of equity for a particular company.
© IFE: 2019 

Cost of equity / Return on equity
For the equity market as a whole:
cost of equity in the market = risk-free rate of return

+ equity risk premium
For a particular company:
cost of an equity share = risk-free rate of return

+ b for share  equity risk premium
© IFE: 2019
CB1 Ch 19: WACC
8
State a formula that shows the effect on the b of a company’s shares of

changing the level of gearing of the company.
© IFE: 2019 

Adjusting b for gearing
 debt 
geared  ungeared  1  1  tax rate  
 equity 
© IFE: 2019
CB1 Ch 19: WACC
9
List THREE methods for measuring the b of an equity.
© IFE: 2019 

Methods for measuring the b of an equity
1. Use historical returns and the formula:

s im
bi =
2
sm
ie use regression and the formula: ri = rf + βi (rm - rf )
2. Estimate based on expected performance of the share price in a given

market environment.
3. Use an industry b based on a group of similar companies, and allow

for the difference in gearing.
© IFE: 2019
CB1 Ch 19: WACC
10
List FOUR factors that will influence the cost of debt (including factors that
affect the credit rating).
© IFE: 2019 

Factors affecting cost of debt / credit rating
1. Interest and asset cover
2. Level of gearing
3. b of the shares
4. Tax treatment of the debt
© IFE: 2019
CB1 Ch 19: WACC
Summary Card
WACC Card 1
Modigliani and Miller Cards 2 to 3
Specific and systematic risk Cards 4 and 5
Beta Cards 6, 8 and 9
Cost of equity Card 7
Cost of debt Card 10
© IFE: 2019 

CB1
Chapter 20
CB1 Ch 20: Capital structure and dividend policy
1
List the THREE components of the capital of a limited company.
© IFE: 2019 

Components of the capital of a limited company
1. Equity
2. Short- and medium-term debt
3. Long-term debt
© IFE: 2019
2
The financial managers of a company seek to maximise the return to

shareholders within the parameters that the shareholders set out.
List FIVE such parameters that shareholders may have.
© IFE: 2019 

Parameters of shareholders when considering shareholder return
1. The variability of anticipated returns
2. Their desire for immediate profit rather than future high growth
3. The degree to which risk should be carried by them
4. Their willingness (or otherwise) to put additional capital into the

business
5. Their willingness to see a reduction in the proportion of the business

that they own
© IFE: 2019
3
State at least THREE reasons why a business might need to change its
capital structure.
© IFE: 2019 

Reasons for changing capital structure
1. To raise money (eg in order to expand the business or to invest in new

capital projects)
2. To dispose of excess cash that it cannot profitably use
3. To adjust its WACC
© IFE: 2019
4
List SEVEN factors that will affect a firm’s decision on an appropriate level of
gearing.
© IFE: 2019 

Factors affecting the gearing decision
1. The nature of the business and its assets
2. Financial risk
3. Costs of debt and equity
4. Availability of debt and equity
5. Control of the business
6. The view of the market
7. Tax
© IFE: 2019
5
Describe how the nature of the assets affects the gearing decision.
© IFE: 2019 

Assets and the gearing decision
Some businesses have lots of assets available as security for loans and so
can use a high proportion of debt financing, eg banks and property companies
can use loans and leased properties as collateral.
Others businesses, eg mining companies or IT developers, will have very

limited tangible assets and will need to rely on equity finance.
Most businesses lie between these two extremes.
© IFE: 2019
6
List FOUR features of corporate taxation that may affect the gearing decision.
© IFE: 2019 

Taxation and the gearing decision
1. Interest payments are tax deductible.
2. Writing-down allowances on new plant and equipment are deductible,

ie companies can reduce their tax liability in respect of the capital
allowances on the plant and equipment they own.
3. Lease of plant and equipment receives tax relief.
4. Property rentals receive full relief and industrial buildings have writing-
down allowances (although at a much lower rate than plant).
© IFE: 2019
7
List FIVE factors that will influence a firm’s decisions on dividend policy.
© IFE: 2019 

Factors influencing decisions on dividend policy
1. Stock markets (don’t like dividend cuts)
2. Cash reserves
3. Tax (and tax position of shareholders)
4. Growth opportunities
5. Stability and consistency
© IFE: 2019
8
Describe scrip or stock dividends.
© IFE: 2019 

Scrip or stock dividends
Stock or share dividends are dividends paid in the form of extra shares, rather
than in cash.
Scrip dividends are either:

 pure (the shareholder has no option to take cash)
 a scrip alternative to a cash dividend.
The dividend will be shown in the company accounts as a transfer from

retained earnings to equity capital.
From the company’s point of view, the scrip dividend retains funds that can be
used for investment or to reduce borrowings.
From the shareholders’ point of view, tax will normally be payable as if cash
dividends had been paid. The scrip issue only really benefits those
shareholders who wish to increase their holdings.
© IFE: 2019
9
Describe share buybacks.
© IFE: 2019 

Share buybacks
If a company has accumulated large amounts of cash which it does not need
in running the business, or if it wishes to change its capital structure by
increasing its gearing ratio, it will may consider a share buyback.
This can be done by:
 purchase of shares in the open market, often by a gradual programme

over a period of time
 a fixed-price offer
 a tender offer (either a Dutch or uniform price auction)
 repurchase by direct negotiation with a major shareholder.
© IFE: 2019
10
List the advantages and disadvantages to the shareholder of a share buyback

operation.
© IFE: 2019 

Advantages and disadvantages to the shareholder of a share buyback
Advantages
 Benefits private shareholders to the extent that the tax treatment of capital
gains is more favourable than that of dividends.
 Should improve earnings per share and hence share price.
Disadvantages
 Investors (especially institutions) prefer to make their own buy and sell
decisions.
Could be either
 Depends on market reaction to the news and the resulting movement in
the share price.
© IFE: 2019
Summary Card
Forms of capital Card 1
Shareholder returns Card 2
Capital structure Cards 3 to 6
Dividend policy Card 7
Scrip dividends Card 8
Share buybacks Cards 9 and 10
© IFE: 2019 

CB1
Chapter 21
CB1 Ch 21: Capital project appraisal (1)
1
Define a capital project.
© IFE: 2019 

Capital project – definition
A capital project is any project where there is initial expenditure (perhaps over
a period of time) and then, once the project comes into operation, a stream of
revenues less running costs.
A capital project does not have to involve the construction of a physical asset.
© IFE: 2019
2
List SIX criteria that may be considered at the initial appraisal stage.
© IFE: 2019 

Initial appraisal criteria
1. The financial results expected, eg NPV, IRR
2. The risk that the results may not be achieved
3. Synergy or compatibility with other projects undertaken by the sponsor
4. Political constraints, both within and without the sponsoring organisation
5. Existence of sufficient upside potential
6. The best use of scarce funds or management resources
© IFE: 2019
3
List FOUR types of cashflow that will arise for most capital projects.
© IFE: 2019 

Types of cashflow
1. Capital expenditure
2. Running costs
3. Revenues
4. Termination costs
© IFE: 2019
4
List TEN methods of evaluating capital projects.
© IFE: 2019 

Methods of evaluating capital projects
1. Net present value

2. Internal rate of return
3. Annual capital charge
4. Shareholder value approach
5. Payback period (and discounted payback period)
6. Nominal returns
7. Strategic fit
8. Opportunity cost
9. Hurdle rates
10. Receipts/costs ratio
Note that opportunity cost and hurdle rates are not independent methods.
© IFE: 2019
5
Describe net present value.
© IFE: 2019 

Net present value (NPV)
The NPV method models all the cashflows of a project until termination and
discounts these back to the present day using the sponsor’s cost of capital.
If the result is positive then the project will improve shareholder returns.
© IFE: 2019
6
Define the internal rate of return.
© IFE: 2019 

Internal rate of return (IRR)
The internal rate of return is the interest rate that gives a project an NPV = 0.
If IRR > cost of capital, the project is expected to be profitable.
© IFE: 2019
7
State THREE practical problems with the IRR.
© IFE: 2019 

Practical problems with the IRR
1. Can give nonsense results if the initial capital is small, giving very high
positive (or negative) solutions, two solutions or no solution at all.
2. Whereas the average NPV of a range of scenarios can be found simply

by summing the value multiplied by the probability of the scenario, the
same is not true for the IRR.
3. The IRR can sometimes have multiple solutions, especially if there are
net negative cashflows at some points during the operating life of the
project or at termination.
© IFE: 2019
8
Describe and discuss the annual capital charge method.
© IFE: 2019 

Annual capital charge
The method expresses the capital outlay as an annual charge, writing off the
capital steadily over a period of years.
This charge may then be offset against the benefits and if the net result is
positive the project or capital expenditure can be approved.
This method is valuable in that it can show the impact on the company’s profit
stream of an investment.
The annual capital charge is similar in concept to the depreciation charged

through the statement of financial position.
This method works well looking at capital expenditure on machinery or plant

and benefits from being simple and easily understood. It should not be ruled
out just because there are more complex methods available.
© IFE: 2019
9
Describe the shareholder value approach.
© IFE: 2019 

Shareholder value approach
The shareholder value approach looks at the present value of all expected
cashflows to shareholders. It extends the NPV approach and looks:
 at the whole company rather than just the project (ie is holistic)
 at the company from the point of view of the external shareholder rather
than internal management
 at the value of the company ‘before the investment’ and ‘after the
investment’
 at how the market values the company, eg price earnings ratio, price to
net assets ratio
 at factors that affect the company’s rating, eg competitors’ reactions.
© IFE: 2019
10
State the main advantage and the main disadvantage of the shareholder value
approach.
© IFE: 2019 

Shareholder value approach
+ Models all the interactions and feedback loops to ensure all the
consequences of the project have been considered
– Highly subjective
© IFE: 2019
11
Describe the payback period.
© IFE: 2019 

Payback period
The payback period is the time it takes for the accumulated cashflows to
become neutral.
Payback can be crucial for small companies that find it hard to raise further
finance.
The method is not much use when payback terms are much > 3 years as it
ignores the time value of money. The discounted version of the payback
period allows for this.
The method is simple and popular.
© IFE: 2019
12
Define the nominal returns approach.
© IFE: 2019 

Nominal returns
This is a variant of the payback method where one simply compares the ratio
of cash generated to cash consumed over a period.
It can give a quick idea of the relative profitability of projects and is an

adequate approach where the ratio can quickly be seen to be high.
As for payback period, the term over which such an evaluation is made should
be short.
© IFE: 2019
13
Describe the strategic fit approach.
© IFE: 2019 

Strategic fit
The strategic fit approach looks at the fit of the project with the rest of the
business.
Projects with a good strategic fit may be approved even if they cannot be
justified on purely financial grounds.
© IFE: 2019
14
Define the receipts/costs ratio.
© IFE: 2019 

Receipts/costs ratio
NPV of the gross revenues

NPV of the capital and running costs
© IFE: 2019
15
Describe the process of carrying out Monte Carlo simulation.
© IFE: 2019 

Carrying out Monte Carlo simulation
1. Model the cashflows of the project allowing for interdependencies and

serial correlations.
2. Specify probabilities for the distribution of each of the key variables

(possibly investigated by the use of sensitivity testing).
3. Simulate the cashflows many times using values extracted randomly

from the distributions of possible variable inputs.
4. Record and order the outputs to assess their probability distributions.
© IFE: 2019
Summary Card
Capital projects Cards 1 and 3
Initial appraisal criteria Card 2
Methods of evaluating projects Cards 4 to 14
Monte Carlo Simulation Card 15
© IFE: 2019 

CB1
Chapter 22
1
Explain what conclusions we can draw if the rate of return on a particular

project is greater than a company’s WACC.
© IFE: 2019 

WACC and the rate of return
If a company is able to generate a rate of return in excess of its WACC from a

particular project, then that project:
 has a positive NPV calculated at the WACC
 will increase the value of the company, where this is calculated as the
NPV all of its future cashflows, and therefore make the shareholders
better off.
All other things being equal, the project should therefore be undertaken.
All other things being equal includes the level of systematic risk of the project
being the same as that of the company.
© IFE: 2019
2
Describe the setting of a risk discount rate (RDR) for projects that are more
risky than the average project for the company.
© IFE: 2019 

Risk discount rate (RDR) for risky projects
Only the systematic risk should be allowed for by varying the discount rate
used.
The RDR used should be greater than that which the company normally
employs, ie add an adjustment to the WACC.
This adjustment could be set by:

 making an arbitrary addition
 looking at other companies who do similar projects
 using a CAPM-based approach to estimate the required return on the
project.
© IFE: 2019
3
Outline the CAPM approach to finding the required return on a project, rp .
© IFE: 2019 

CAPM approach to the required rate of return
rp  rf  β p  rm  rf 
Estimating β p is a matter of judgement, but issues to consider include:
 cyclicality
 operating gearing (ie proportion of fixed as opposed to variable costs).
© IFE: 2019
4
In appraising a capital project, state how:

 systematic risk
 specific risk
should be dealt with.
© IFE: 2019 

Dealing with systematic and specific risk
Systematic risk should be allowed for in the RDR.
Specific risk should be allowed for by specific risk analysis.
© IFE: 2019
5
Define certainty equivalents.
© IFE: 2019 

Certainty equivalents
The projected individual risky cashflows are replaced with their certainty
equivalents, ie the projected element of the cashflow adjusted for risk alone,
and then discounted at a uniform discount rate.
© IFE: 2019
6
Explain what is meant by a risk to a capital project.
© IFE: 2019 

Risk
A risk is either an event which leads to a variation from the most likely
outcome in either direction or the probability of occurrence of such an event.
Many risks are downside, in that they involve a worsening of the outcome of
the project if they occur, but the analysis should also take account of possible
upside variations in the same way.
© IFE: 2019
7
List the steps involved in specific risk analysis.
© IFE: 2019 

Specific risk analysis
 Identify risks
 Analyse risks
 Investigate mitigation options for downside risks
 Consider the cost of the mitigation options and select best mitigation
options
 Control residual risks
© IFE: 2019
8
Describe risk control measures that should be put in place for controlling the
residual risks of a capital project.
© IFE: 2019 

Risk control measures
Risk control measures include:

 regular monitoring of the risks
 plans for dealing with foreseeable and unforeseeable crises
 appointment of risk custodians
 regular management reviews.
© IFE: 2019
9
Outline the steps necessary to achieve an effective identification of the risks

facing a capital project.
© IFE: 2019 

Steps to achieve an effective identification of the risks facing a capital
project
1. Make a high-level preliminary risk analysis.
2. Hold a brainstorming session of project experts and senior internal and

external people who are used to thinking strategically about the long
term.
3. Carry out a desktop analysis to supplement the results from the

brainstorming session. A risk matrix is useful at this stage.
4. Carefully set out all the identified risks in a risk register, with cross
references to other risks where there is interdependency.
© IFE: 2019
10
List SEVEN sources of risk in a risk matrix.
© IFE: 2019 

Sources of risk in a risk matrix
1. Political
2. Business
3. Economic
4. Project
5. Natural
6. Financial
7. Crime
These are usually represented as columns in the risk matrix.
© IFE: 2019
11
List the successive stages of a capital project as listed in the risk matrix.
© IFE: 2019 

Stages of a capital project in a risk matrix
1. Promotion of concept
2. Design
3. Contract negotiations
4. Project approval
5. Raising of capital
6. Construction or implementation
7. Operation and maintenance
8. Receiving revenues
9. Decommissioning or closing down
These are usually represented as rows in the risk matrix.
© IFE: 2019
12
Having identified the risks, state the items that should be considered for the
company to analyse them.
© IFE: 2019 

Risk analysis
Risk analysis involves considering the:

 frequency
 consequences or impact
 independence or correlation
 controllability / extent of possible mitigation
 expected NPV
of each risk.
© IFE: 2019
13
Describe TWO common methods for obtaining a distribution of NPVs for a

project.
© IFE: 2019 

Scenario analysis
Construct a series of future scenarios, each representing a combination of

possible outcomes for the major risk events and each having its own
probability of occurrence, obtained by combining the probabilities of the
various independent component risks.
Stochastic modelling
Build a computer-based stochastic model, in which the various risks are

modelled and a series of simulations is then run to get a probability distribution
of the NPVs.
Although stochastic models would seem superior, the data assumptions can
be difficult to obtain and the results can be spuriously accurate and lead to
overconfidence in the output.
Both methods may show unfavourable outcomes that warrant further

investigation.
© IFE: 2019
14
List SIX ways to mitigate risks in a capital project.
© IFE: 2019 

Mitigating risks in capital projects
1. Further research to reduce uncertainty

2. Avoid the risk by redesigning the project
3. Transfer the risk through use of contracts or out-sourcing
4. Share the risk with other companies
5. Insure the risk
6. Reduce the risk by redesigning the project
These can be recalled using the acronym FAT SIR
© IFE: 2019
15
List FOUR ways that each risk mitigation option can be evaluated.
© IFE: 2019 

Evaluating risk mitigation options
1. The likely effect on the frequency, consequence of expected value of

the risk
2. Feasibility and cost of implementing the mitigation option
3. Secondary risks that result from the option, and whether these can be
mitigated
4. Impact of each option on the distribution of expected NPVs for the
project
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16
List SIX issues that can impact the choices made by decision makers (or
‘project sponsors’) after a project has been submitted.
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Decision makers may be influenced by:
1. Allowance for biases in the estimates made in the project appraisal

2. A hunch
3. Knowledge that they possess that might not be in the hands of the
project team
4. Last minute developments
5. Doubts about the feasibility
6. Credibility issues about the project appraisal
© IFE: 2019
Summary Card
Risk discount rate Cards 1 to 3
Risk definitions Cards 4 to 6
Specific risk analysis Card 7
Risk control and identification Cards 8 and 9
Risk matrix Cards 10 and 11
Risk analysis Card 12 and 13
Mitigating risks and decision making Cards 14 to 16
© IFE: 2019 

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CB1 Flashcards 2019

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Business Finance

The Actuarial Education Company

Flashcards may be used to complement your other study and revision

Outline the TWO basic decisions involved in company finance.

© IFE: 2019 

1. The capital budgeting (or investment) decision

2. The financing decision

In relation to a company’s financial decisions, outline the responsibilities of

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The treasurer is normally responsible for the financing decisions. The

Ultimately, the board of directors is responsible for all financial decisions.

Describe the contractual theory of the firm.

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Contractual theory views a firm as a network of contracts, actual and implicit,

Most participants bargain for limited risk and fixed payoffs.

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Outline agency theory.

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Agency theory considers the relationship between a principal (eg a company’s

Outline the theory of the maximisation of shareholder wealth.

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Provided that a free, competitive, capital market exists, shareholders can

If we assume that all shareholders seek to be as rich as possible, then the

The presence of the capital markets' continuous assessment therefore

State FIVE key effects of the capital markets on a firm’s decisions.

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1. Sound investment decisions require accurate measurement of the cost

2. Limitations in the supply of capital focus attention on methods of raising

3. Mergers and takeovers create threats and opportunities to be exploited.

4. ‘Externalities’ require managers to determine the appropriate role of

5. The capital markets' continuous assessment stimulates efficiency and

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 Attitude towards risk

Define corporate governance.

State the role of the following in UK corporate governance:

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Corporate governance is the system by which companies are directed and

Boards of directors are responsible for the governance of their companies.

The shareholders’ role in governance is to appoint the directors and the

The FRC is responsible for setting the UK Corporate Governance and

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5. Relations with shareholders

Financial decisions Cards 1 & 2

Contractual theory of the firm Cards 3 & 4

Agency theory Card 5

Capital markets Cards 6 to 8

Corporate governance Cards 9 & 10

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Name FOUR types of business entity.

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4. Limited liability partnership

Define a sole trader.

State the extent of a sole trader’s liability.

State the documentation required to set up as a sole trader.

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No specific documentation is needed to establish legally as a sole trader.

State the extent of a partner’s liability.

State the documentation required to establish a partnership.

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A partnership is a business which is owned by more than one person and

Strictly, no specific documentation is needed to establish legally a partnership

Define a limited company.

State the extent of a shareholder’s liability.

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