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INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

26 April 2012 (am)

Subject CT2 Finance and Financial ReportingCore Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answerbooklet.

2. You must not start writing your answers in the booklet until instructed to do so by thesupervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 20 questions. Fromquestion 11 onwards begin your answer to eachquestion on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and thisquestion paper.

In addition to this paper you should have available the 2002 edition of the Formulaeand Tables and your own electronic calculator from the approved list.

CT2 A2012 Institute and Faculty of Actuaries

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CT2 A20122

For questions 110 indicate in your answer book which one of the answers A, B, C or D iscorrect.

1 Why should an eligible bill of exchange be regarded as a very secure investment?

A The issuer is eligible to issue secure bills of exchange.B The holder of the bill is eligible to claim repayment in full at any time.

C The bill has been guaranteed by a bank.D The bill has been drafted by an eligible intermediary.[2]

2 What aspect of a limited liability partnership (LLP) is limited?

A The liability of individual members is limited to 100,000.

B The liability of individual members is limited to their agreed share of thepartnerships liabilities.

C No member can suffer loss due to the acts or omissions of another member.

D The LLPs creditors cannot normally seek payment from the membersthemselves.

[2]

3 A quoted company made a substantial rights issue. A shareholder who had asubstantial shareholding did not wish to take up the right to buy shares and forgot to

sell those rights.

Which of the following best describes the effects of this forgetful shareholdersactions?

A The forgetful shareholder was worse off because of the rights issue and theother shareholders were unaffected.

B The forgetful shareholder was worse off because of the rights issue and theother shareholders were better off.

C The forgetful shareholder was unaffected by the rights issue and the othershareholders were better off.

D The forgetful shareholder was unaffected by the rights issue and the othershareholders were worse off.

[2]

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CT2 A20123 PLEASE TURN OVER

4 Which of the following best supports the assertion that the payment of a dividendsignals confidence on the part of the directors?

A The dividend is paid out of past profits that have actually been earned.B The directors are keen to receive dividends from their own shareholdings.C The directors have to find the cash with which to pay the dividend.D The shareholders will react badly to the non-payment of a dividend.

[2]

5 The net present value criterion is generally claimed to provide the most consistent andrelevant basis for the selection of investment projects.

Which of the following situations creates the greatest threat to the validity ofevaluating projects using net present value in practice?

A Net present value ignores risk.

B Shareholders may disagree with the results of a net present value calculation.

C The calculation of net present value can lead to two solutions.

D Managers may wish to undertake the project for selfish reasons and couldmanipulate the analysis.

[2]

6 A companys external auditorincluded an emphasis of matter in the audit report.

Which of the following statements best describes the meaning of an emphasis ofmatter?

A The auditor wishes to draw attention to an important matter that has beendisclosed in the notes to the financial statements.

B The auditor wishes to draw attention to the limitations of the work undertakenduring the audit.

C The audit report is being qualified.

D The auditor disagrees with the information in the financial statements.[2]

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CT2 A20124

7 Which of the following is most likely to arise as a consequence of the moneymeasurement concept?

A Assets will be recorded at cost.B Some valuable assets will be excluded from the financial statements

altogether.C Expenses will be accrued regardless of when the associated payment is made.

D Assets will not be written down to their break-up values. [2]

8 Which of the following statementsrelating to current assets is correct?

A Current assets will be realised within one year.

B Current assets have short expected useful lives.

C Current assets comprise cash and items that will be converted into cash in the

normal course of business.

D Current assets always comprise inventories, receivables, bank and cash.[2]

9 Which of the following best explains why investment analysts often calculateEarnings before Interest, Taxation, Depreciation and Amortisation (EBITDA)?

A EBITDA is less prone to fluctuations and volatility than net profit.

B Depreciation and amortisation are not real costs to the business.C Investment analysts are only interested in performance before tax.D EBITDA is regarded as less prone to manipulation than net profit.

[2]

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10 Net assetvalue per share is calculated by subtracting intangible assets from ordinaryshareholders equity and dividing the remainder by the number of shares in issue.

Which of the following best explains the relevance of net asset value per share?

A In the event that the entity is wound up the chances are that its intangibleassets will not have any market value, but the shareholders will be certain to

receive the value of the remaining net assets after disposal.

B In the event that the entity is wound up the net asset value per share is likely torepresent the best possible outcome that the shareholders can expect.

C The shareholders should monitor the net asset value per share and should insistthat the entity be wound up in the event that net asset value per share exceedsthe market value of the companys shares.

D Net asset value per share is likely to correspond to the value that an unquotedcompanys shares would have on the open market.

[2]

11 Explain why, from a tax perspective, many individual shareholders prefer to earn areturn from an increase in the share price rather than payment of a dividend. [5]

12 Martha is seeking funding for a company that she wishes to establish. Her plansinvolve too much risk for a conventional bank loan but a venture capital company hasoffered to invest in convertible loan stock.

Discuss the disadvantages to Martha of funding her company by issuing convertibleloan stock to a third party. [5]

13 Outline the uses to which currency futures can be put. [5]

14 Four engineers have established a company to manufacture a new product that theyhave patented. Each of the directors owns 25% of the companys equity. They haveemployed a qualified accountant to manage the companys record-keeping and to

engage with potential lenders on the companys behalf.

Describe the respective legal responsibilities of both the companys directors and itsaccountant in relation to record-keeping and lenders. [5]

15 Explain how a lessee can take on the risks and rewards of ownership of an asset, eventhough the leased asset remains the property of the lessor. [5]

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CT2 A20126

16 Explain how there could be a conflict between the interests of directors andshareholders over the raising of additional finance, where the directors would preferthe company to issue equity and the shareholders would prefer the company toborrow. [5]

17 Explain why accounting information that is relevant may not be reliable and why

accounting information that is reliable may not be relevant. [5]

18 Discuss the usefulness and limitations of a companys annual report to the companyslenders. [5]

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19 Barton manufactures animal feed using machinery that is both very simple and veryrobust. The company has operated independently since it was founded.

Bartons primary product cannot be manufactured using modern technology andBarton faces very little competition within its market niche. The product is popularwith horseracing stables and other horse owners who wish to promote the health andstamina of their animals.

Bartons owner is planning to retire and has offered to sell the company to Nufeed, ananimal feed business that manufactures animal feed using heavily industrialisedprocesses. Nufeed is interested in acquiring Barton because it will complement itsexisting product range and will demonstrate Nufeeds commitment to manufacturingtraditional products using traditional methods.

Bartons owner proposes that the companys selling price should be set bymultiplying the most recent profit figure by a multiple that has yet to be agreed.Nufeeds chief financial officer is reviewing Bartons financial statements in order toestablish whether that is a realistic suggestion.

Bartons property, plant and equipment figures are as follows:

All of Bartons property, plant and equipment is shown at cost less depreciation.Property is depreciated at a rate of 2% of cost every year and plant and equipment at arate of 4% of cost.

Property comprises a large factory building located in the countryside, close to severallarge farms that provide the companys raw materials.

Plant and equipment comprises heavy milling and mixing equipment that was built toBartons specifications when the company was established. The equipment ismaintained to a very high standard by Bartons head of production, who has workedfor the company for almost 20 years.

Propert

Plant and

equipment Total

000 000 000

Cost

As at 31 March 2011 800 250 1,050

Additions 50 9 59

As at 31 March 2012 850 259 1,109

Aggregate depreciation

As at 31 March 2011 272 170 442

Charge for yea 16 10 26

As at 31 March 2012 288 180 468

Net book value

As at 31 March 2012 562 79 641

As at 31 March 2011 528 80 608

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CT2 A20128

Nufeed commissioned a report on the plant and equipment. The report stated that itwould cost at least 1.2 million to replace the production machinery. With the correctmaintenance, this type of equipment can have a very long useful life, but very fewengineers have the skills to repair ongoing wear and tear. In the absence of such askilled maintenance team, the bearings would wear out after approximately ten years,resulting in the scrapping of the equipment.

The equipment has almost no resale value because it is too large and heavy to bedismantled and removed.

Nufeeds chief financial officer has asked Bartons owner to restate the depreciationcharge to deal with the effects of inflation. Bartons owner has refused on the basisthat it could be argued that depreciation ought to be zero because the plant andequipment has no market value. Furthermore, he has not asked Nufeed to payanything for Bartons good name and loyal customer base because neither of thoseassets is recognised in the companys statement of financial position (balance sheet).

(i) Explain why it appears that Bartons depreciation charge may have been

understated. [5]

(ii) Calculate an alternative more relevant depreciation charge for Bartons plantand equipment that would better reflect the use of these resources. [3]

(iii) Explain the logic underlying your depreciation calculation. [3]

(iv) Outline the logic behind Bartons owners claim that the depreciation chargeshould be zero. [3]

(v) Discuss the validity of the claim made by Bartons owner that he has not

charged Nufeed anything for the companys reputation and customer base. [6][Total 20]

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CT2 A20129

20 Manor is a quoted property company that specialises in the development and resale ofcommercial office buildings. The company frequently invests in large projects thatrun for between three and five years, with that being the typical timescale from theacquisition of a new property to its resale after redevelopment.

Manor evaluates potential investments using the net present value (NPV) criterion.The NPVs of all proposals are calculated using a discount rate of 8% p.a. The

criterion has been in place for at least the past ten years. The finance director isunhappy that the companys principal investment criterion has been in place for solong that none of the present senior executives were in post when it was introduced.As a result, nobody knows the reasons for its selection. That has become an issue inrecent years because the property market has been depressed and most of theinvestment opportunities have offered a negative NPV when discounted at 8% p.a.The shareholders are beginning to become anxious that the company is not putting itsassets to good use because the proceeds of selling developed properties are beingbanked instead of being reinvested in fresh projects.

The chief executive has asked the finance director to consider the following

possibilities:

Calculate the NPV using a discount rate of 5% p.a., at least until the propertymarket improves and creates the possibility of higher returns.

Continue to discount investment opportunities at 8% p.a., but take a moreoptimistic view of future cash flows from projects under consideration. Mostprojects have a range of possible outcomes and many become desirable whenevaluated using the best possible outcome for costs and revenues rather than themost likely.

(i) Discuss the validity of Manors policy of using an 8% p.a. discount rate whencalculating the NPV of investment opportunities. [8]

(ii) Discuss the logic behind reducing the discount rate for evaluating projects to5% p.a. until the property market improves. Your discussion should coverboth the validity of the proposed reduction in the discount rate and the likelyimpact on Manors share price. [8]

(iii) Discuss the validity of evaluating projects using the best possible forecastoutcomes instead of the most likely. [4]

[Total 20]

END OF PAPER

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INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT

April 2012 examinations

Subject CT2 Finance and Financial ReportingCore Technical

Introduction

The Examiners Report is written by the Principal Examiner with the aim of helpingcandidates, both those who are sitting the examination for the first time and who are usingpast papers as a revision aid, and also those who have previously failed the subject. TheExaminers are charged by Council with examining the published syllabus. AlthoughExaminers have access to the Core Reading, which is designed to interpret the syllabus, theExaminers are not required to examine the content of Core Reading. Notwithstanding that,the questions set, and the following comments, will generally be based on Core Reading.

For numerical questions the Examiners preferred approach to the solution is reproduced inthis report. Other valid approaches are always given appropriate credit; where there is acommonly used alternative approach, this is also noted in the report. For essay-style

questions, and particularly the open-ended questions in the later subjects, this report containsall the points for which the Examiners awarded marks. This is much more than a modelsolution it would be impossible to write down all the points in the report in the time allowedfor the question.

T J BirseChairman of the Board of Examiners

July 2012

Institute and Faculty of Actuaries

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Subject CT2 (Finance and Financial Reporting) April 2012 Examiners Report

Page 2

General comments on Subject CT2

This paper examines basic finance including raising funds by a variety of methods, taxation,net present value and project appraisal and other topics, it has both calculations and essaytype questions on these topics. The paper also examines financial reporting including

preparation of the main financial statements and interpretation of financial statements it alsoconsiders the basis of the preparation of statements and the information needs of a variety ofend users of financial statements.

Different numerical answers may be obtained to those shown in these solutions depending onwhether figures obtained from tables or from calculators are used in the calculations butcandidates are not penalised for this. However, candidates may be penalised where excessiverounding has been used or where insufficient working is shown.

Comments on the April 2012 paper

Although, the general performance was slightly poorer than in September 2012, well-prepared candidates scored well across the whole paper. As in previous diets, overseascandidates did not perform quite so well as UK candidates. The comments that follow thequestions concentrate on areas where candidates could have improved their performance.Candidates approaching the subject for the first time are advised to concentrate their revisionin these areas. The main questions that caused candidates difficulty were Q19 and 20.

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1 C2 D3 B4 C

5 D6 A7 B8 C9 D10 B

The MCQs were done well.

11 Most individual shareholders pay income tax at their highest marginal rate when theyreceive any dividend income. They have very little opportunity to manage thatliability and so tax will almost certainly become payable whenever a dividend isreceived.

If the company retains earnings then, in theory, the share price will rise. Shareholdersare not taxed on that gain unless they realise it by selling their shares. That gives theshareholders an opportunity to plan their pattern of taxable gains in any given yearbecause they can time the realisation by delaying the sale of their shares if they sowish.

In addition, individual shareholders receive an annual allowance that can reduce theamount paid on gains beneath the allowance to zero. Furthermore, the tax rate oncapital gains is generally lower than that which would be suffered on income.

This question was done well by candidates with most having good knowledge of the taxsystem.

12 The advantages to the lender generally cause equivalent disadvantages to the

borrower. Martha will have to find the cash to pay interest on the bonds during thedebt phase of the instrument. While that interest may be payable at a lower rate thanwould be paid on an outright loan, it is still a commitment that the new business willhave to make.

In the event that Marthas business succeeds, the chances are that the bondholder willconvert the bond to shares. That will dilute her equityand will reduce her return fromhaving taken the initiative to start this business and work to make it a success. Thus,the bond will impose all of the downside risks associate with borrowing when thebusiness is at its most vulnerableand will reduce the upside risks associated with anysuccess that the business enjoys.

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This question was not done well by candidates In general points written down were too fewand at too high a level.

13 Currency futures can be used to manage risk exposures. The most logical use for afuture would be to manage downside risk on a future receipt or payment of foreign

currency. For example, if a company had made a sale to a foreign customer and hadbeen forced to invoice in the customers currency there could be a risk that the rateswill move adversely during the period before settlement. A currency future could beentered into so that the sum due is sold for delivery at a future date, therebyguaranteeing the companys future receipt. The only significant cost would be theinterest foregone on the margin deposit that would have to be made.

Futures can also be used to create a substantial exposure for speculative purposes. Aninvestor who predicted a significant shift in a particular currency that appears to havebeen mispriced could enter into a futures contract in order to obtain a more significantposition than could be possible using cash reserves to buy and hold the currency itself.

This question was done badly my many candidates. Many answers were extremely brief andhad very little detail.

Candidates had very little knowledge of this area. Many knew what futures were, but did notknow much more and were unsure what they were for.

14 The directors are ultimately responsible for the companys administration and anyrelationships that it develops with third parties. They cannot make somebody else

responsible for those matters even if their expertise in engineering means that they arenot particularly well equipped in business or financial management. They can, ofcourse, delegate the actual work of maintaining books or talking to banks to afinancial manager if they so wish.

The companys accountant will be required to fulfil the duties that are spelled out inthe contract of employment. Those duties may have to be discharged in accordancewith standards imposed by the accountants professional body. The directors will bearthe ultimate legal responsibility for ensuring that the company is compliant with allrelevant legislation, but the directors will be entitled to expect that the work will becompleted to a very high standard of quality.

This question was answered reasonably well.

15 The lessee may sign a lease that grants the right to use the asset for a specified periodthat amounts to virtually the whole of the assets anticipated useful life. Provided thelessee makes the agreed lease payments the lessor will have little or no rights over theasset. Thus, the lessee can make full use of the asset for most or all of its useful lifeand thereby enjoys the full rewards of ownership.

Such lease arrangements are unlikely to be cancellable because the lessor willnormally acquire the asset to meet the lessees specifications. The lease payments will

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continue even if the asset becomes obsolete or redundant because the lessees needschange. The lessee will almost certainly have to agree to accept responsibility for anyloss or damage to the asset while it is in the lessees custody. Thus, the lessee willeffectively have to pay for the cost of the asset plus interest (via the lease payments)and suffer all the risks of ownership in the process.

This question was answered well by most candidates.

16 The shareholders prefer the entity to borrow, within reason, because debt is cheaperthan equity. The shareholders enjoy the benefit of the wealth created from the lendersinvestmentand they also enjoy the benefits of the tax shield on borrowing. The risksassociated with borrowing are borne directly by the company and so the shareholderswill not have to risk their personal assets in the event that the company fails.

The directors are more directly exposed to the risks of gearing. If the company failsbecause it cannot meet its loan commitments then the directors will face the loss oftheir jobs. If they issue further shares then the shareholders will be unlikely to everhave an incentive to put the company into receivership because they will loseeverything that they have invested.

This question was answered very well by most candidates.

17 Relevant information is generally future-oriented. Users find information relevant if itinforms decisions that have to be made and that will typically involve a comparison of

the outcomes the different decisions will have. For example, the decision as towhether an asset should be retained or sold requires an understanding of the futurecash flows that it will generate and also of the amount that it will realise on the openmarket.

Information is reliable if it can be checked easily and measured against an objectivebenchmark. Generally, reliable information is historical and may not necessarily havemuch predictive value. For example, the historical cost of an asset is a very reliablemeasure because it can be verified against its associated invoice.

This question was done reasonably well the part on reliable information was poorer than the

section on relevant information.

18 The financial statements are prepared by the directors and audited with a view toinforming the shareholders. The figures in the financial statements may be designed toreport past profitability, whereas the lenders would prefer a conservative evaluation ofthe present position to inform decisions about collectability. The information in thefinancial statements is largely historical, whereas lenders are primarily interested infuture cash flows to ensure that they are capable of servicing a loan commitment. Thestatement of financial position will list the companys debts and the assets that are

available to settle them and so that gives an insight into security, but the asset values

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Page 6

are not necessarily guaranteed in the event of a failure and associated disposal underconditions of duress.

There is also a problem in that the annual report is not sufficiently frequent for thelender to monitor the security of an advance.

This question was not done very well by candidates. The answers were usually too short andgeneral. Many candidates only wrote two sentences. This was not enough to pass thequestion, as the allocation of marks available indicates.

19 (i) Depreciation is effectively the recognition of the fact that an entity consumesresources in the form of property, plant and equipment when manufacturinggoods. Bartons depreciation charge is based on a percentage of the historicalcost of the assets being used. Bartons assets are very old and so thosehistorical costs have become virtually meaningless. The resulting depreciationfigure is perfectly consistent with accounting regulations, but it is notnecessarily representative of the costs being incurred when reporting todecision makers. Any comparable business would have to report a muchhigher depreciation charge because it could not acquire assets for the sameprice as Barton. The property is stated at historical cost and therefore thedepreciation charge is likely to be lower than if it was charged on currentvalues.

This question was done very poorly with a surprising number of candidates having little ideawhat depreciation is.

(ii) Notional cost of assets =1.2mNotional useful life =10 yearsCharge =1.2m/10 =120,000 per annum

This question was straightforward but was generally not answered correctly.

(iii) This charge is calculated on the basis that the replacement cost of the assets ismore relevant than their historical cost. The resulting depreciation recognisesthe economic cost of the wear and tear.

The useful life is based on the argument that ten years is realistic when thecompany does not employ a craftsman such as Bartons head of production.Even if Barton has such an employee in post, there is no guarantee of retainingthat person indefinitely and so the artificially long lives of the assets will becurtailed.

This question was also not done well. Candidates had difficulty with the idea that having acraftsman as head of production could affect the useful life.

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(iv) The negotiation of the selling price of a business is complicated by the factthat accounting regulations do not necessarily lend themselves to everysituation. Bartons machinery has been fully depreciated on a historical costvaluation and the fair value of the assets is normally determined by looking attheir market valuation, which is also zero. Thus, Bartons owner can claim that

depreciation on production machinery is zero and such a claim is consistentwith accounting regulations. If the owner insists on making the best possibleuse of this loophole then profit may be overstated and that could be used as anargument to inflate the selling price for the business.

This question was answered incorrectly by many candidates who felt that the market valuewas relevant to the depreciation calculation.

(v) The proposal involves basing the selling price on a multiple of profit. Thatautomatically incorporates the effects of the factors that the owner hasmentioned. The companys good name and customer base will have

contributed to past profits and so they are included in the valuation of thecompany as a going concern. The fact that they are not being priced separatelydoes not mean that they are being excluded altogether.

It could be argued that the good name will become less valuable if Barton istaken over and becomes associated with a large and modern company. Part ofthe reason for companys success in this niche is the fact that it is a smallcompany manufacturing in a traditional way.

This part of the question was poorly answered with some candidates just missing it out.

20 (i) This criterion takes some account of the time value of money. It also requiresall investments to achieve positive NPV using a discount rate that has,presumably, been arrived at through trial and error or on some other basis.

Perhaps the standard discount rate of 8% p.a. will not reflect the risks of anyparticular project, but the alternative would be to invest significant time andeffort in determining a more realistic target for each investment and there is noguarantee that the resulting figures will be any more suitable. All investmentdecisions require subjective decisions about the risks and returns.

The fact that Manor is investing in property means that it is fairly unlikely thatit will be faced with a massive risk of loss on a project, even if it is necessaryto hold an investment until a market blip sorts itself out. Also, the fact that theprojects have a typical life of three to five years means that using a differentdiscount rate would have very little impact on the overall net present value.More stringent criteria would be justified in the case of a different industrywith longer project lives, but the impact in this case would not be material.

This part was not done very well by candidates. They generally did not mention the scenarioset out in the question at all but just discussed NPV in general terms.

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(ii) There is no justification for reducing the discount rate just to make moreprojects appear to be profitable. It would make just as much sense to abandonproject appraisal altogether and simply accept all projects on some randombasis.

If the market is declining then that might suggest that it is riskier and a higherdiscount rate than 8% p.a. should be used.

If the shareholders discover that the company is seeking only a modest returnon its investments then the share price will decline. Logically, the shareholderswill evaluate projects using their own evaluation of risk and return and theshare price will decline if the company accepts projects that have a negativeNPV when evaluated in the shareholders terms.

Clearly, the shareholders will not necessarily be aware of investments unlessthe directors inform them. Even if the fact that an investment is being made is

disclosed, the directors will not publish their forecasts on NPV calculations.

If the directors do make a series of poor investments because of this strategythen the shareholders will only become aware of that when the results of thoseinvestments start to appear in the published accounts. It may take at least twoor three years before a series of weak returns starts to impact on reportedROCE.

This part was done badly by almost all candidates. Candidates did not mention shareholdersand did not discuss the discount rates in any detail. Where candidates discussed this in part(i) credit was given.

(iii) The most obvious risk is that any evaluation based on best possible isunlikely to achieve the anticipated results and is likely to be a disappointment.The shareholders will almost certainly wish the directors to evaluate anyprojects on the basis of the outcomes that are likely to be achievedand theymay regard the use of will lead to the acceptance of best possible as adishonest attempt to justify unsuitable investments.

It could be worth considering the best possible outcome as one aspect ofdecision-making. Risky projects often have an upside potential as well as a

downside and so the possibility that an upside may be enjoyed is worthconsidering as one factor in choosing between competing projects.

This part of the question was done better than parts (i) and (ii).

END OF EXAMINERS REPORT

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