INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS
21st May 2008

Subject CT2 – Finance and Financial Reporting

Time allowed: Three Hours (10.00 – 13.00 Hrs)

Total Marks: 100

INSTRUCTIONS TO THE CANDIDATES

1. Do not write your name anywhere on the answer sheets. You have only to write your
Candidate’s Number on each answer sheets.

2. Mark allocations are shown in brackets.

3. Attempt all questions, beginning your answer to each question on a separate sheet.
However, answers to objective type questions could be written on the same sheet.

4. Fasten your answer sheets together in numerical order of questions. This, you may
complete immediately after expiry of the examination time.

5. Candidates should show calculations where this is appropriate.

6. In addition to this paper you should have available graph paper, Actuarial Tables
and an electronic calculator.

Professional Conduct:
“It is brought to your notice that in accordance with provisions contained in the Professional Conduct
Standards, If any candidate is found copying or involved in any other form of malpractice, during or in
connection with the examination, Disciplinary action will be taken against the candidate which may include
expulsion or suspension from the membership of IAI.”

Candidates are advised that a reasonable standard of handwriting legibility is expected by the examiners
and that candidates may be penalized if undue effort is required by the examiners to interpret scripts.

AT THE END OF THE EXAMINATION

Please return your answer scripts and this question paper to the supervisor separately.
 IAI CT2 0508

Q. 1) Which of the following is treated as a credit item in the trial balance

I. Investment income
II. Short term investments
III. Credit purchases
IV. Depreciation

Options: - A. – IV only
B. – II and III
C. – I and IV
D. – I only [2]

Q. 2) Which of the following strategies would not help a company to reduce its exposure to
rising interest rates?

i. The negotiation of an interest rate swap

ii. The purchase of a put option on an interest rate future
iii. The purchase of a bond future
iv. The sale of an interest rate future [2]

Q. 3) NTP Ltd paid Rs. 5,75,000 for 1,00,000 shares in PFC Ltd. PFC Ltd’s share capital
was 1,50,000 shares of Rs. 3 per equity share, and at the time of the share purchase it
had reserves of Rs. 75,000. Calculate the goodwill associated with the purchase.

i. Rs. 2,75,000
ii. Rs. 50,000
iii. Rs. 2,25,000
iv. Rs. 5,00,000 [2]

Q. 4) The following information is based from the accounts of JMW Ltd for 2007 and 2008

2007 2008
Sales 6,00,000 7,50,000
Net profit before tax and interest 60,000 90,000
Long-term loans 75,000 2,25,000
Share capital 75,000 90,000
Reserves 37,500 60,000

Which of the following is true about the performance of JMW Ltd: -

A. The return on capital employed has fallen because the fall in the asset
utilization ratio has outweighed the rise in the profit margin
B. The return on capital employed has risen because the asset utilization ratio
has risen
C. The return on capital employed has risen because the profit margin has
risen
D. The return on capital employed has fallen because the fall in the profit
margin has outweighed the rise in the asset utilization ratio [2]

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 IAI CT2 0508

Q. 5) Which of the following is NOT a requirement for a published report and accounts?
A. The accounting policies selected must be judged to be the most
appropriate for giving a true and fair view of the financial position of the
company
B. The accounts should be compiled assuming that the company is a going
concern
C. Income and expenditure should be taken into account in the year in which
it is earned or incurred respectively.
D. The accounts should be calculated on a prudent basis [2]

Q. 6) Which of the following is least likely to give rise to agency costs?

A. A software company which employs managers to carry out day-to-day
operations.
B. A heavy vehicle manufacturing company where there are managers and
unions working together.
C. An oil rigging company where government takes a great interest.
D. A retailing business where owner is the manager [2]

Q. 7) Which of the following is NOT a valid reason for using simulation in order to
evaluate an investment project?
A. The cash flows are uncertain.
B. The required rate of return might vary during the life of the project.
C. Decision makers are interested in the range of possible outcomes.
D. Decision makers require an accurate forecast. [2]

Q. 8) XYZ plc is a listed company. Which of the following is a specific risk that can be
diversified away by shareholders?
A. XYZ Plc is highly geared and it is exposed to increases in interest rates.
B. XYZ Plc has a great deal of foreign competition and so changes in
exchange rates can affect its competitive position.
C. XYZ Plc’s main product line requires a steady supply of a rare mineral
that is only found in a region that is politically unstable.
D. XYZ Plc produces luxury goods, demand for which is highly vulnerable
to change in the economic climate. [2]

Q. 9) You are an actuarial consultant helping a leading manufacturing company ABC Plc
in evaluating the projects they want to undertake and the following information is
provided. At 16% discount rate the NPV of Project A is INR 350,000 and NPV of
Project B is INR 500,000. Which of the following are correct statements?
A. The payback period need not be considered in evaluating the projects.
B. If ABC Plc has set a hurdle rate of 16% then both the Projects are viable.
C. Project A is preferable for Project B.
D. The internal rate of return for Project A is higher than the Project B.
[2]

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 IAI CT2 0508

Q. 10) Which of the following is the most appropriate basis for determining the required rate
of return on a major project considered by a quoted company?

A. The company’s weighted average cost of capital (WACC).

B. The interest rate on the bank loan raised in order to finance the project.
C. A specific rate for the project determined according to project’s total risk.
D. A specific rate for the project determined according to the project’s
systematic risk [2]

Q. 11) Explain how tax might influence the shareholders’ preference for debt financing
versus equity financing in the company’s gearing decision. [5]

Q. 12)
a) Who are the main stakeholders in an organization and why might their
interest conflict? (5)

b) In ABC proprietary company all share holders seek to be as rich as possible in

such situation what is the objective of financial managers? (1.5)

c) Capital Markets provide information that will help the financial manager to
take the decisions – Discuss. (3.5)
[10]
Q. 13) a) What is the meaning of the word “quotation”? List all the methods of
obtaining quotation. (3)

b) Company P Ltd has borrowed at variable interest rates and wants to protect
itself against increase in market interest rates-

i) What kind of options would they use? (0.5)

ii) How will these options minimize the above risk? (2.5)

c) Neeta is considering buying shares in Company P Ltd, but is concerned by the

fact that the company has a large number of options outstanding that might
dilute her investment-
i) Explain what is meant by dilution in this context, and (2)
ii) Explain how it might affect Neeta’s investment. (2)
[10]

Q. 14) a) Hilliard Corp. wants to calculate its weighted average cost of capital (WACC).
The company’s CFO has collected the following information:

• The company’s long-term bonds currently offer a yield to maturity of 8 percent.

• The company’s stock price is $32 per share (P0 = $32).
• The company recently paid a dividend of $2 per share (D0 = $2.00).
• The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%).

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IAI CT2 0508

• The company pays a 10 percent flotation cost whenever it issues new common
stock (F = 10%).
• The company’s target capital structure is 75 percent equity and 25 percent debt.
• The company’s tax rate is 40 percent.
• The company anticipates issuing new common stock during the upcoming year.

What is the company’s WACC? (10)

b) A large multinational insurance company is considering a major international

expansion. The directors of the company are considering investing heavily in a
feasibility study in order to determine whether to start their operations in a new
country. There are many factors that would determine the success or otherwise
of this new venture. For example:

• The fixed costs may be high as it may be difficult to get suitable staff without
offering very substantial salaries.
• It is difficult to predict how competing firms who are already established in that
country will respond to the competition.
• The new host country’s currency is very volatile compared to the company’s
home currency and all profits from the new office would be earned in that host
currency.
The feasibility study is a very costly undertaking in itself and so the firm is
considering the respective merits of the following three options:

• Conduct a feasibility study, prior to making a decision to whether proceed.

• Proceed with the expansion without first undertaking a feasibility study.
• Abandon the whole idea of the expansion.
One of the directors of the firm has prepared a probability tree using the following
assumptions:
• If the expansion goes ahead it will yield either of the following outcomes:
Success (with a positive net present value (NPV) of INR 50 lacs) and Failure
(with a negative NPV of INR 10 lacs)
• The feasibility study will cost INR 100,000 and will have an 80% probability of
correctly predicting the outcome of the expansion.
• There is a 70% probability that the feasibility study will indicate that the
expansion will succeed and a 30% probability that it will indicate failure.
• If the expansion proceeds without the feasibility study it has a 62% probability
of success and a 38% probability of failure.

Using these assumptions one of the directors of the company has prepared the
following probability tree and claims that the expansion is likely to prove successful,
but the firm should undertake the feasibility study nevertheless.

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 IAI CT2 0508
Success INR
50 lacs

0.8

INR
36.0
lacs

0.2
Yes

Expand + 36.0 Failure INR -

lacs 20 lacs

No
Success INR 50 lacs
0

Indicate Success 0.7 0.8

INR
36.0
INR lacs
25.2
lacs
Indicate Failure 0.3 0.2
Yes
Yes – Cost Rs 10 lacs

Expand + 0 Failure INR -

Conduct lacs 20 lacs
feasibility study
+INR 24.2 lacs
No

No – Cost 0 0 Success INR 50 lacs

0.62

INR
23.4
lacs

0.38
Yes

Expand + 23.4 Failure INR-

lacs 20 lacs

No

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 IAI CT2 0508

Another director has prepared a simulation of the investment and has simulated the
outcome of proceeding for 10,000 cycles. This suggests that the expected net present
value of the expansion is negative, whether the feasibility study is conducted or not.

i). Explain why the probability tree suggests that the firm should conduct the
feasibility study, even though the expansion is likely to be success. (2)
ii). Explain when it might be appropriate to use a probability tree in the evaluation of
a capital investment project. (2)
iii). Explain why the other director’s simulation exercise may be more reliable than
the probability tree.
(2)
iv). Describe the prerequisites of a “Successful” simulation of a capital investment
project. (2)

v). It has been suggested that managers often use capital investment appraisal
techniques in order to justify decisions that they have already taken. State, with
reasons, whether or not you agree with this suggestion. (2)
[20]
Q. 15) a) Define the following ratios and explain the main limitations of these ratios: -

i). Income Cover (1.25)

ii). Asset Cover (0.75)

b) The following ratios have been calculated from financial statements of two
companies of similar size and same industry:-

Y LTD S LTD
Gross Profit Ratio 40% 20%
Net Profit Ratio 32% 16%
Return on capital employed 10% 14%

Explain which of the two companies is more profitable and why? (3)

[5]

Q. 16) a) Name 4 users of financial statements and explain with reasons there interest
in financial Statements? (4)

b) Topspin Ltd is in the process of preparing its balance sheet for 31st December
2002. So far, the items (valued at 31st December 2002 unless otherwise
stated) are:

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 IAI CT2 0508

Rs’000
Non-current assets at cost 672
Accumulated Depreciation (as on 31st December 2001) 175
Current Assets 290
Long- term loans 125
Share Capital 225
Share premium 75
Revaluation reserve 155
Retained earnings (as on 31st December 2001) 180

For the year to 31st December 2002:

• The depreciation figure in the income statement is Rs 12,000
• The profit after tax is Rs 30,000
• The directors distributed half of the company’s earnings to its shareholders in
the form of a dividend.

The company’s accountants take the view that the company’s non-current assets
should be revalued at Rs 7, 25,000.

Prepare the balance sheet of Topspin Ltd at 31st December 2002 taking into
account the revaluation of the non – current assets. (2)
[6]

Q. 17) A company has experienced volatile earnings in the last 5 years. The underlying
business is unpredictable and risky and involves a high proportion of overseas
earnings. List the steps the management can take to reduce the volatility in reported
earnings for equity share holders.
[4]

Q. 18) a) What are subsidiaries and associates companies? (2)

b) Explain the following statements: -

i. Balance sheet always “balance” why? (3)

ii. Going concern assumption may simplify the preparation of financial

statements, how? (3)

c) The balance sheets as on 31–03 –2006 and 31-03-2005 of Gupta textiles

limited are given below:-

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IAI CT2 0508

Rs in Lakhs
31-03-2006 31-03-2005
Fixed Assets at Cost 750 700
Less depreciation (400) (350) 350 350
Investments 250 300
Stock 162 255
Trade debtors 215 250
With Bankers 175 130
Total Assets 1,152 1,285

Share Capital 150 150

Reserves 237 115
12% Secured Debentures 2010 350 300
Trade Creditors 140 243
Provision for taxation 140 249
Provision for dividend 135 228
Total liabilities 1,152 1,285

During the financial year 2005-2006, the following transactions took place: -

• Sales 1,000
• Raw material and wages at factory 412
• Office expenses and wages at office 155
• Net return on long term investments 8%
• Tax charge on 2005-2006 profits 111
• Purchase of machinery on 31-3-2006 50
• Issue of further Debentures on 2-4-2005 50

Prepare the Profit & Loss Account and Cash flow statements for the financial year
) 2005-2006. (12)
[20]
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