INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2016 (with mark allocations)

CT2 – Finance and Financial Reporting

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.

F Layton
Chairman of the Board of Examiners
June 2016

 Institute and Faculty of Actuaries

 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2016 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. The aim of the Finance and Financial Reporting subject is to provide a basic
understanding of corporate finance including a knowledge of the instruments used by
companies to raise finance and manage financial risk and to provide the ability to interpret
the accounts and financial statements of companies and financial institutions.

2. 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 essay type questions on these topics. The paper also examines financial reporting
including preparation of the main financial statements and interpretation of financial
statements it also considers the basis of the preparation of statements and the
information needs of a variety of end users of financial statements.

3. Different numerical answers may be obtained to those shown in these solutions

depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be
penalised where excessive rounding has been used or where insufficient working is
shown.

B. General comments on student performance in this diet of the

examination

The general performance was similar to results in the past, well-prepared candidates scored
well across the whole paper. As in previous diets, overseas candidates did not perform quite
so well as UK candidates. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Candidates approaching the
subject for the first time are advised to concentrate their revision in these areas. The main
problem was Q19, however many candidates scored high marks in most questions.

C. Pass Mark

The Pass Mark for this exam was 60%.

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 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2016 – Examiners’ Report

Solutions

Q1 C [2]
Q2 D [2]
Q3 D [2]
Q4 C [2]
Q5 A [2]
Q6 B [2]
Q7 B [2]
Q8 C [2]
Q9 B [2]
Q10 D [2]

Questions 1–10 were done well by most candidates. No particular question

caused a problem for candidates.

Q11 Individuals have an annual allowance for capital gains, which means that some capital
gains are effectively tax free. [1]
Individuals usually pay tax at a lower rate on capital gains than on income. [1]
Capital gains are not taxed until the gain is realised. [1]
Thus, tax can be delayed by deferring the disposal of the shares until the taxpayer
requires the cash. [1]

Some taxpayers have very low incomes and will be able to offset dividends against
their personal allowances. [1]

Taxpayers will tend to gravitate towards companies whose dividend policies are
consistent with their tax preferences. [1]
[MAX 5]

Candidates did reasonably well in this question. The candidates had mixed
results with some doing very well and less prepared candidates doing very
badly.

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 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2016 – Examiners’ Report

Q12 Existing shareholders may benefit from the fact that convertibles can offer lower
interest rates during the loan phase. [1]
That could be a permanent benefit in the event that the conversion is optional and the
lenders choose not to convert. [1]
The convertible may also be the only way in which the company will be able to attract
investment to fund a positive NPV project that will benefit the shareholders. [1]

The possibility of conversion also means that the company will not have to bear the
risk of being unable to raise sufficient cash to repay the loan. [1]

The disadvantage is that the conversion will almost certainly be on terms that are
advantageous to the lender. [1]
That is effectively a cost to the existing shareholders because their equity will be
diluted and their personal wealth will be reduced. [1]
[MAX 5]

This question was done well by most candidates.

Q13 The fact that the company is quoted means that it will find it much easier to raise
funds to expand. [1]

The shareholders will now have the means to liquidate their investments so that their
wealth is no longer tied up in the company. [1]
The stock market price will enable the shareholders to value their shares for tax
purposes in the event of, say, a gift of shares to a relative. [1]

The shareholders will have to sacrifice their control because of the need to sell shares
to a wider base. [1]
The company will also be subject to far greater scrutiny because of its quoted status.
[1]
Managerial decisions will be evaluated in terms of their impact on the share price. [1]
[MAX 5]

This question had the highest marks of all the short questions.

Q14 Business cultures vary with respect to borrowing. In some countries it is the norm to
seek equity funding whereas there is greater use of debt in others. [1]
Local shareholders will be nervous if a company exceeds the normal limits, but they
will also be dissatisfied if the opportunities afforded by debt are passed up due to
excessive reliance on equity. [1]

The fundamental difference is the attitudes of banks and other stakeholders. [1]
In some countries, the banks are tolerant of companies that are faced with temporary
difficulties with cash flow. [1]

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 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2016 – Examiners’ Report

If the lender is likely to support a borrower through a difficult period then the
bankruptcy risks associated with gearing are reduced. [1]
The stability of the local economy is also an issue. [1]
If the local economy is steady then the volatility in operating profit that is accentuated
by gearing is less likely to occur. [1]
[MAX 5]

This question was done reasonably well by many candidates but there were
also some very weak attempts.

Q15 Investment analysis requires far more than a quantitative analysis such as the
calculation of NPV. Firstly, a number of assumptions have to be made in order to
determine future cash flows. [1]
Those assumptions must be made explicit and justified and the appraisal document
offers the opportunity to do so. [1]

Completing the document creates the framework for evaluating the project in a
systematic and disciplined manner. [1]
For example, there can be a formal requirement to evaluate risks and the project’s
strategic fit with the company overall. [1]
The document makes it far more difficult for the sponsors to present an optimistic and
one-sided analysis. [1]

The document will also assist with the project’s management because it will specify
various plans and objectives that can be used to measure progress once the project is
under way. [1]
[MAX 5]

This question was done well by many candidates.

Q16 The first step is to identify the variables that should be taken into account in the
simulation. [1]
For example, interest rates and other economic variables may affect consumer
spending and so those will have to be introduced as factors. [1]
Then the project’s cash flows will have to be modelled using estimates based on the
factors. [1]
An attempt will have to be made to determine how an increase in interest rates might
affect demand. [1]
This model will be complicated, otherwise there will be little point in using
simulation. [1]

The model should be run repeatedly until the average of the results obtained settle
down. [1]
The model can be run with different assumptions to determine which assumptions are
important in terms of the sensitivity of the results. [1]

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 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2016 – Examiners’ Report

The results have to be analysed carefully because they will provide an indication of
the distribution of expected returns. [1]
The wider the disparity between best, worst and most likely returns the greater the risk
associated with this investment. [1]
[MAX 5]

This question was done badly with many candidates giving very short answers.

Q17 The cash flow statement indicates whether the entity is capable of generating cash
from its operations. [1]
In the short term, profit is not a good indicator of cash flow because there are so many
variables that can affect profit but not cash and vice versa. [1]
The company’s future could be in jeopardy if its cash is not properly managed. [1]

In the absence of a cash flow statement, the only measure of cash movements would
be the increase or decrease in the bank balance from one year end to the next. [1]

The cash flow statement provides a formal description of the cash inflows and
outflows, all linked to common themes such as investment activities. [1]
The shareholders can then see where the company is raising cash from and where the
resulting funds are being spent. [1]
[MAX 5]

This question was done badly by many candidates.

Q18 The revaluation reserve arises because book values have been revised upwards in
order to reflect the fair values of the company’s assets. [1]
The balance indicates that the figures in the statement of financial position are
potentially more relevant than if the assets had been left at cost less depreciation. [1]

While it may be argued that the entity has generated additional shareholder wealth
through holding the assets that have been revalued, the danger is that the gain has not
been realised. [1]
The shareholders cannot expect a fresh increase in the revaluation reserve to lead to an
increase in dividends. [1]
Indeed, the gains may have to be reversed in the future if market changes mean that
the fair values decline. [1]

The revaluation of property, plant and equipment may lead to greater subjectivity in
the financial statements. [1]

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 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2016 – Examiners’ Report

That will extend to the statement of profit or loss because there will be additional
depreciation being charged. [1]
[MAX 5]

This question was done very badly by a significant number of candidates.

Q19 (i) The most important issue is whether Parrent can exercise control of Subb. [1]
Parrent will have to demonstrate that by showing that it can compel Subb to
behave in the manner that suit’s Parrent’s interests. [1]

The fact that Parrent does not own sufficient shares to exercise control is
irrelevant because control can be obtained through other means. [1]
In this case, Parrent can appoint board members to Subb’s board, which
implies the possibility of control. [1]
Presumably, there will be sufficient appointees to carry votes at board
meetings or the directors appointed by Subb will have enhanced voting rights.

The fact that Parrent can create consolidated financial statements that include
Subb indicates that it can exercise sufficient control to obtain the necessary
facts and figures. [1]
[Total 5]

(ii) Shareholders have limited liability. [1]

Parrent is no more responsible for Subb’s liabilities than any other shareholder
in the event of a default. [1]
If Subb is unable to meet its obligations then Parrent would be well within its
rights to leave Gryffe’s balance unpaid. [1]

It is debatable whether it would be in Parrent’s best interests to behave in this

manner. Firstly, permitting Subb to fail would probably mean that Parrent
would lose its investment and it would have to report a loss in its financial
statements. [1]
Secondly, the opportunity to participate in future profits from Subb would be
lost. [1]
Finally, Parrent’s reputation would suffer. [1]
[Max 5]

(iii) The external auditor reports on the truth and fairness (or fair presentation) of
the financial statements. [1]
That means that the statements offer stakeholders a credible basis upon which
to base decisions. [1]

The audit report makes no mention of the strength or security of the company
itself. [1]
It is for the readers to read and interpret the financial statements and to decide
how to behave. [1]

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 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2016 – Examiners’ Report

The delays inherent in publishing financial statements means that the

information on Subb’s short-term liquidity will be out of date by the time that
the annual report becomes available. [1]
The external auditor will not accept any explicit responsibility towards the
users of the audited financial statements. [1]
The auditor will not, for example, compensate Gryffe if it suffers a loss
because of a bad credit decision. [1]
[Max 5]

(iv) The first step would be to request that Parrent grants Gryffe a formal guarantee
in support of Subb. [1]
That would mean that Gryffe would then have a legal right to pursue Parrent in
the event of any default by Subb. [1]

Gryffe may also attempt to reduce the risk of having to pursue Parrent for
payment. One approach to doing so would be careful credit control
procedures. [1]
All receivables should be monitored and slow payment investigated and
pursued. [1]
Slow payers could have their credit facilities suspended or even withdrawn. [1]

Gryffe could also set a credit limit, effectively restricting the maximum
exposure to loss in the event that Subb defaults. [1]
[Max 5]
[TOTAL 20]

This question was not done well. Parts (i) and (ii) were generally reasonably
well done, but parts (iii) and (iv) were done very badly. This resulted in many
candidates failing this question.

20 (i) Ratios

Pensions Insurance Risk

ROCE 2205/(3861+1600) = 40% 2705/(3663+1600) = 51% 1746/(1248+800) = 85%
Fees/salaries 11,000/7700 = 143% 9000/5400 = 167% 3600/1440 = 250%
Net profit % 2205/11000 = 20% 2705/9000 = 30% 1746/3600 = 49%
[1 mark per ratio – Max 5]

While Risk is the smallest department, it could be argued that it is the most
profitable.

The department’s return on capital employed is greater than either of the other
two. [1]
This means that the department produces more profit for every £ invested than
the others. [1]
(The very high ROCEs is not surprising given the nature of this business,
which is not really capital intensive.) [1]

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Subject CT2 (Finance and Financial Reporting Core Technical) – April 2016 – Examiners’ Report

The margin on the Risk department’s salaries is also higher. [1]

Risk can charge £250 fees for every £100 of salaries. This means that the
company can actually make more profit from work done in this department
than in either of the other two. [1]

The Risk department also has a higher net profit percentage, which suggests
that overheads are not disproportionately high. [1]

If anything, Jute should consider expanding Risk to take advantage of the

higher margins and returns which can be obtained from this type of work.

It should also be noted that all three departments are being charged with
significant centralised costs that would still be borne even if the departments
ceased to operate. [1]
That strengthens the business case for retaining all of them.
[Max 5]

(ii) (a) The average time taken to convert salaries into fees is essentially the
inventory turnover ratio:

3,672/14,540 × 365 = 92 days [1]

(b) Average time taken for customers to settle bills:

1,467/23,600 × 365 = 23 days [1]

[Total 2]

(iii) The company’s quick ratio is (5,629 – 3,672)/1,357 = 1.44:1 which appears to
be reasonably healthy. [1]
It has, however, got a month's salary outstanding and relatively little cash with
which to pay it. [1]
This means that the company could find it difficult to continue trading. [1]

The main problem is that the company has two steady drains on cash: salaries
and loan interest. [1]
Income is much more erratic, being dependent on invoicing clients for work
done. [1]
[Max 4]

(iv) Invoices are settled very quickly after being presented to customers. [1]
The most important means by which the company could improve its cash
flows is by speeding up the invoicing process. [1]
This could mean scheduling work so that projects can be completed so that
invoices can be raised. [1]
Contracts with new clients should also be negotiated on the basis that work
can be invoiced at regular periods. [1]

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 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2016 – Examiners’ Report

Given the company’s pressing need, the most reliable solution would be to
seek an injection of cash from a bank or some other source. [1]
[Max 4]
[TOTAL 20]

This question was done well by many candidates. The weakest part was
part (iii), the rest were good.

END OF EXAMINERS’ REPORT

Page 10
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2015

Subject CT2 – Finance and Financial Reporting

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.

F Layton
Chairman of the Board of Examiners
December 2015

 Institute and Faculty of Actuaries

 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2015 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. The aim of the Finance and Financial Reporting subject is to provide a basic
understanding of corporate finance including a knowledge of the instruments used by
companies to raise finance and manage financial risk and to provide the ability to interpret
the accounts and financial statements of companies and financial institutions.

2. 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 essay type questions on these topics. The paper also examines financial reporting
including preparation of the main financial statements and interpretation of financial
statements it also considers the basis of the preparation of statements and the
information needs of a variety of end users of financial statements.

3. Different numerical answers may be obtained to those shown in these solutions

depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be
penalised where excessive rounding has been used or where insufficient working is
shown.

B. General comments on student performance in this diet of the

examination

The general performance was similar to results in the past, well-prepared candidates scored
well across the whole paper. As in previous diets, overseas candidates did not perform quite
so well as UK candidates. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Candidates approaching the
subject for the first time are advised to concentrate their revision in these areas. The main
problem was Q19, however many candidates scored high marks in all questions.

C. Comparative pass rates for the past 3 years for this diet of examination

Year %
September 2015 64
April 2015 61
September 2014 60
April 2014 54
September 2013 57
April 2013 66

Reasons for any significant change in pass rates in current diet to those in the
past:

The pass rate for this examination diet is slightly higher than the April 2015 rate, but not
materially different. Variation in the pass rate between sessions is expected as different
cohorts of students sit the examination.

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 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2015 – Examiners’ Report

Solutions

Q1 C
Q2 C
Q3 C
Q4 D
Q5 C
Q6 A
Q7 A
Q8 C or D was accepted
Q9 D
Q 10 C

Workings:

Q3 Net profit discounted at 8% = $11,000  3.993 – 40,000 = $3,923

Cash flow discounted at 8% = $19,000  3.993 – 40,000 = $35,867 (Correct)
Net profit discounted at 6% = $11,000  4.212 – 40,000 = $6,332
Cash flow discounted at 6% = $19,000  4.212 – 40,000 = $40,028

Questions 1–10 were done well by most candidates. No particular question

caused a problem for candidates.

Q11 Principals are often forced to appoint agents to make decisions on their behalf.
The agents’ economic interests may be in conflict with those of the principal.
Principals may be exposed to losses because their delegation of authority and control
may mean that they fear that the agents will also control the information at their
disposal to monitor them. The agents could, for example, overstate performance in
order to retain their jobs or increase their bonuses. The fear of manipulation may lead
to costly and restrictive monitoring activities. Agency costs could also reduce market
prices.

This question was answered well by many candidates.

Q12 Personal gearing can enable the shareholders to obtain the effect of a lower cost of
Capital from borrowing and they can invest the proceeds in equity shares to get the
additional return. This will not be a perfect substitute. The shareholders are unlikely to
obtain the same low rate that could be obtained by the company. Furthermore,
corporate gearing permits the shareholders to enjoy limited liability. Personal gearing
would leave the shareholders personally liable. They may also wish to leave their
personal borrowing capacity free for personal purposes. Tax is also an issue. The

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 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2015 – Examiners’ Report

company can claim interest as an expense for tax purposes, whereas the shareholders
cannot.

This question was done very badly by candidates who did not understand
what personal gearing was and had difficulty coming up with any sensible
solution to the question.

Q13 Finance leases may be attractive to lenders because they automatically provide a
degree of security. The lessor retains ownership of the asset and so it will be
relatively easy to take possession of it in the event that the lessee runs into financial
difficulty. The lessor’s security may result in a lower finance charge than would be
the case with a standard term loan. The lessee can structure the lease in a manner
that fits with its requirements and can cease to be responsible for the asset from the
conclusion of the lease. Having said that, the lease arrangement may prove
inflexible. If, say, the lessee wishes to replace the asset then it may be more difficult
to do so. The lessor would be entitled to insist on the lease commitment being
honoured, whereas an asset that has been purchased outright can be sold and the
proceeds used to offset the outstanding loan. The lessee benefits from the fact that
the lessor is protected and can charge a lower rate.

Some candidates discussed tax issues and creative accounting issues which
was excellent, these points are not covered in core reading but candidates
were awarded marks for these points. This question was answered well.

Q14 The fact that the shares are unquoted means that the outcome of the offer may be
difficult to predict. The underwriter has to ensure that the risks of bearing significant
losses from any failure in the offering are adequately priced. The risks could arise
from unexpected quarters, such as economic news that depresses markets generally.
Fresh information could also emerge from the due diligence associated with the
floatation. The underwriter must ensure that a realistic fee is charged, bearing in
mind that there is a market and that overpricing could result in the loss of the
business.

This question had a mixed response with some very good answers and some
poor ones.

Q15 Banks generally have a specific advantage with respect to raising variable rate finance
(if bank deposits are viewed as loans) . Banks often attract significant amounts of
variable rate debt and would often prefer to convert some of that to fixed rate. A
portfolio of fixed and variable rate will leave the bank less exposed to movements in
interest rates. Furthermore, many of the bank’s financial assets will take the form of
fixed-interest loans to customers and so there could be a mismatch between assets and
liabilities. Swaps enable them to make best use of their specific advantage and to

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 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2015 – Examiners’ Report

convert some of that to fixed rate to the mutual benefit of the bank and the
counterparty.

This question was answered badly with many candidates showing no

knowledge of swaps.

Q16 Tax relief on contributions makes it cheaper for individuals to save for retirement
through pensions. There may also be a less onerous rate of tax on the pension
income after retirement. Taxpayers on higher rates will often find these tax benefits
to be of particular value because the tax subsidy should be proportionately greater
for them.

Companies might also receive tax relief on the payments they make towards
providing for pensions.

The pension scheme may not be taxed on its investment income in the same way that
another investor would.

Pensioners may be permitted to take out tax-free lump sums.

This question was not answered well with many candidates ignoring many of
the taxation implications.

Q17 The key to creative accounting is that the rules appear to have been complied with
even though the figures are potentially misleading. One approach that may be taken
could be the aggressive manipulation of estimates. For example, the depreciation
charge requires an estimate of the lives of property, plant and equipment. The
company could appear to charge the correct amount of depreciation by overstating
expectations, while remaining within the limits of credibility. The directors could
argue that any subsequent correction arising from the disposal of the assets was due
to a misunderstanding.

Any form of creative accounting was awarded marks, many candidates

answered this question very well.

Q18 Return on capital employed determines whether the profit justifies the funding tied up
in the business. If the ROCE is acceptable then the shareholders should be satisfied
that the company is earning sufficient profit to enhance their wealth. The other
profitability ratios can be viewed as secondary, in the sense that they provide insight
into the ROCE. The fact that ROCE is acceptable does not mean that the shareholders
and managers would be willing to forego any potential improvement. For example,
the gross profit percentage could indicate that the company could change its trading
strategy in order to further increase gross profit and so enhance ROCE. Ratio analysis

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 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2015 – Examiners’ Report

is a complicated undertaking and so it would be very short-sighted to rely on a single

ratio.

This question was answered very well.

Q19 (i) The share price is effectively the net present value of anticipated cash flows. A
fresh investment should create the expectation of further cash flows and so the
share price should increase.

In practice, though, the markets may anticipate investment in capital projects.

Sophisticated investors may have taken the possibility of a degree of
investment in new projects into account when making the buy/sell decisions
that determine the share price. This new project could simply confirm an
expectation that had already been built into the share price.

It is also possible that the market may not agree with the directors’ optimism.
Commercial sensitivity may mean that the shareholders are not given full
disclosure of expected returns and future cash flows. That would mean that the
shareholders would be unlikely to have the same confidence as the directors.
The shareholders may feel that the risks are greater than the director’s claim
because the directors will benefit in the short term from appearing to have
made an astute investment.

(ii) An asset’s beta coefficient reflects the systematic risks of that asset. Specific
risks are diversified away, leaving the volatility of returns in the asset relative
to the volatility of returns on the market rate as a whole.

Global’s own beta would be relevant if the systematic risks affecting the
project are the same as those affecting Global as a whole. It is unlikely that this
project would have the same risk characteristics as the company because the
two entities operate at different stages in the business cycle. If the price of oil
rises then that may be adverse from the point of view of most market
participants and so capital markets may decline. Global buys oil and so it may
be affected in the same way as the market. The new investment is likely to be
more attractive when the price of oil increases because it will enable Global’s
licensees to extract more oil that is now more valuable. Beta can also be
affected by capital structure and so we may have to adjust for Global’s gearing
ratio.

The oil exploration company’s beta may be less than 1.00 because it is more
affected by unsystematic risks such as whether it strikes oil. The industry is
potentially capital intensive and so interest rates may have a large part to play in
the company’s exposure to systematic risks. The price of oil could also affect
the company’s performance and an increase in oil prices would be desirable
from the company’s point of view. It is difficult to decide how that links the
new venture’s performance to that of the business. Interest rates are unlikely to
affect the new venture, although oil prices will. Using a beta of less than 1.00

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 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2015 – Examiners’ Report

also implies a low cost of capital, which may have the effect of making
Global’s board appear a little reckless.

The product design company may have some aims in common with Global’s
new venture because both are about making the best use of available
resources. Having said that, the product-design company is unlikely to have
the same exposure to systematic risk as the new venture. The use of a beta of
1.00 would suggest that the company is as volatile as the market a whole. That
may prove to be a defensible argument to use with respect to this new venture.

Part (i) – Some candidates gave a reasonable answer to this section although
may candidates made a poor attempt.

Part (ii) – This part of the question was done very badly as candidates did not
understand systematic risk at all. Very few candidates discussed the oil
industry in any depth.

Q20 Maxload Ltd

Statement of Profit or Loss for the year ended 31 August 2015

£000

Revenue 147,800
Cost of sales (111,540)
Gross profit 36,260
Selling and distribution (17,770)
Administrative expenses (12,500)
Operating profit 5,990
Finance charge (4,000)
Profit before tax 1,990
Tax expense (5,600)
Loss for the year (3,610)

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 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2015 – Examiners’ Report

Maxload Ltd
Statement of Changes in Equity for the year ended 31 August 2015

Equity Retained
shares earnings Total
£000 £000 £000

Opening balance 75,000 21,180 96,180

Loss for the year (3,610) (3,610)
Dividend (15,000) (15,000)
Closing balance 75,000 2,570 77,570

Maxload Ltd
Statement of Financial Position as at 31 August 2015

£000

Non-current assets 112,890

Current assets
Inventory 3,770
Trade receivables 12,350
Bank 4,580
20,700
Total assets 133,590

Equity
Share capital 75,000
Retained earnings 2,570
77,570
Non-current liabilities
Loan 45,000

Current liabilities
Trade payables 2,700
Accruals 2,720
Tax 5,600
11,020
133,590

Page 8
Subject CT2 (Finance and Financial Reporting Core Technical) – September 2015 – Examiners’ Report

Note

Non-current assets
Plant and
Property equipment Total
£000 £000 £000

Cost 98,000 90,410 188,410

Depreciation
Opening balance 14,560 48,530 63,090
Charge for year 1,960 10,470 10,470
Closing balance 16,520 59,000 75,520
Net book value 81,480 31,410 112,890

Workings

Cost of sales
Manufacturing overheads 6,870
Opening inventory 2,640
Production staff wages 10,870
Purchases 82,500
Closing inventory (3,770)
Property depreciation 1,960
Plant and equipment
depreciation 10,470
111,540
Selling and distribution
Sales staff commission 5,200
Sales staff salaries 11,850
Accrued commission 720
17,770
Administrative expenses
Administrative staff salaries 2,680
Directors’ salaries 4,200
External audit fee 3,620
Directors’ bonuses 2,000
12,500
Accruals
Sales staff commission 720
Directors’ bonuses 2,000
2,720

Page 9
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2015 – Examiners’ Report

This question was done very well by many candidates with some scoring full
marks. It was excellent to see so many really good attempts.

END OF EXAMINERS’ REPORT

Page 10
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2015 examinations

Subject CT2 – Finance and Financial Reporting

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context at the date the
examination was set. Candidates should take into account the possibility that circumstances
may have changed if using these reports for revision.

F Layton
Chairman of the Board of Examiners

June 2015

 Institute and Faculty of Actuaries

 Subject CT2 (Finance and Financial Reporting) – April 2015 – Examiners’ Report

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 essay
type questions on these topics. The paper also examines financial reporting including
preparation of the main financial statements and interpretation of financial statements it also
considers the basis of the preparation of statements and the information needs of a variety of
end users of financial statements.

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

Comments on the April 2015 paper

The general performance was similar to results in the past, well-prepared candidates scored
well across the whole paper. As in previous diets, overseas candidates did not perform quite
so well as UK candidates. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Candidates approaching the
subject for the first time are advised to concentrate their revision in these areas. The main
problems were Q15, 16, 19 and 20, however many candidates scored high marks in all
questions.

Page 2
 Subject CT2 (Finance and Financial Reporting) – April 2015 – Examiners’ Report

1 B
2 A
3 A
4 B
5 A
6 B
7 B
8 A
9 C
10 D

Workings

5 2 years 10 months = £700,000/(180,000 + 70,000)

3 years 11 months = £700,000/180,000
6 years 4 months = £700,000/(180,000 – 70,000)
10 years = asset life

7 £1,650,000 = £200,000 + 1,700,000 – 250,000

£2,550,000 = £200,000 + 1,700,000 + 900,000 – 250,000
£2,600,000 = 1,700,000 + 900,000
£2,650,000 = £200,000 + 1,700,000 + 900,000 + 250,000

8 £190,000 = (910,000 – 260,000) – (700,000 – 240,000)

£210,000 = 910,000 – 700,000
£230,000 = (910,000 + 260,000) – (700,000 + 240,000)
£650,000 = 910,000 – 260,000

10 £60,000 = 20% × (900,000 – 600,000)

£180,000 = 20% × 900,000
£280,000 = 20% × (800,000 + 600,000)
£340,000 = 20% × (800,000 + 900,000)

Questions 1–10 were done reasonably well by most candidates, no particular question
caused problems.

Page 3
 Subject CT2 (Finance and Financial Reporting) – April 2015 – Examiners’ Report

11 The most immediate implication is that the taxpayer has a much greater degree of
control over the timing of tax payments. Tax can be delayed indefinitely simply by
retaining the asset. Sales can be timed to make the best possible use of any tax
allowances.

Taxpayers do not need to pay tax until they are raising cash from the disposal of the
asset. That avoids having to be forced to sell an appreciating asset in order to raise
cash to pay tax on the capital gains.

The gain is based on an actual transaction, so it can be determined with greater

accuracy.
The tax system may deter the disposal of assets because of the need to pay tax on the
gain arising from a disposal.

This question was answered well by most candidates.

12 Debentures are generally secured against assets, with the debenture holder being paid
before virtually any other creditor. That level of security means that the debenture
holder does not need to receive a very high rate of interest.

It may be necessary to seek permission from the debenture holder before an asset that
has been pledged can be sold.

There is very little prospect of flexibility in the event of a problem. The debenture
holder will have the right to force the sale of the assets that form the security and so
any cash flow problems could prove catastrophic.

This question was answered well by many candidates.

13 The lessor now owns the building and so runs very little risk in the event that the
software company defaults on the rent payments. That makes this a relatively
inexpensive financing package for the software company.

The software company will no longer benefit from any capital appreciation on the
office building. Presumably the lessor will be able to increase rents over the long-
term if property prices rise.

This is the software company’s only real asset. It now has nothing to pledge as
security in the event of raising further funds at some future date.

This question was answered well by many candidates.

Page 4
 Subject CT2 (Finance and Financial Reporting) – April 2015 – Examiners’ Report

14 There is a risk that the company will find itself in difficulty if it has insufficient cash
left after the dividend payment. The shareholders may question the wisdom of paying
the full dividend in these circumstances and so the directors may simply appear
reckless.

The payment of a dividend is generally regarded as a fairly robust sign of confidence.

If the directors believe that the company can afford the dividend then it may reassure
the shareholders.

The fact that the directors are generally reluctant to reduce the dividend payment
means that any reduction or suspension will be seen as convincing evidence that the
company is in trouble. There may be a disproportionate reduction in the share price.

This question was answered well by many candidates.

15 The beta value is basically determined by regressing returns on a security against

those from the market as a whole. There is no real reason to believe that the beta will
remain constant from period to period. Different market conditions may affect the
return on the security in different ways and so changes in, say, interest rates may
affect the security more than, say, changing currency values.

If investors are attracted by particular systematic risk profiles then that could affect
the demand for a security and even that could alter the beta to some extent. Strong
demand could drive up share prices regardless of the market situation and that could
raise or lower the beta.

This question was not done well. Few candidates demonstrated more than basic knowledge
of betas. The marks were quite low with many candidates scoring less than half marks. In
the past questions on beta have been done well so this was surprising. Very few candidates
had any knowledge of systematic risk.

16 The fact that there are two periods with net outflows can create the possibility of a
second IRR. If discount rates are very small then the cost incurred at the conclusion
of the project will have much greater significance and that could be enough to make
the net present value negative.

This project has a positive NPV when the required rate of return is greater than 2% or
less than 9%. There is not a single hurdle rate, but the cost of capital can be related to
the IRR in the same manner as for any other project.

It is unlikely that the company will be looking for a return of less than 2%, so this
project appears to be worth accepting provided the company is willing to accept a
return of 9% or less.

This question was done badly.

Few candidates demonstrated reasonable knowledge of IRR or NPV. Few candidates
commented on the hurdle rate.

Page 5
 Subject CT2 (Finance and Financial Reporting) – April 2015 – Examiners’ Report

17 Strategic fit can be thought of as a non-monetary benefit that can be obtained from an
investment. The fact that the project is a good fit with the business means that it may
create future opportunities for expansion or it may reduce certain risks. The fact that
this company is operating flights between a number of countries may make it ideally
suited to exploit synergies such as using surplus space on aircraft to carry freight.
These opportunities might be difficult to foresee at the evaluation stage of the project
and they will be lost if the company does not take the occasional chance on an
opportunity that may yield dividends.

This question was answered well by many candidates.

18 Accounting standards make accounting statements far more credible. Shareholders

have the means to specify the manner in which the figures are determined and so have
a better understanding of the figures prepared by the directors.

Mutual understanding of the figures will reduce contracting costs. Lenders can
specify debt covenants in terms of accounting numbers with no real concern that the
directors will manipulate accounting numbers in order to reduce, say, the gearing
ratio.

Accounting standards provide auditors with the basis for checking the fair
presentation of the financial statements.

This question was answered very well.

19 (i) It could be argued that the assets and liabilities in respect of the charity
transaction should be excluded from the calculation of the current ratio.

February January
Gross profit margin 532/(900  200) = 76% 525/700 = 75%
Current ratio (1,042 + 29)/185 952/360 = 2.6:1
= 5.8:1
Trade receivables 1,010/900 × 31 720/700 × 31
turnover = 35 days = 32 days
Trade payables 185/(368 – 200) × 31 360/(175 + 200) × 31
turnover = 34 days = 30 days

The table above shows the most likely versions of the acceptable answers.
The following alternatives are acceptable:

February January
Trade receivables 1,010/900 × 365/12 720/700 × 365/12
turnover = 34 days = 31 days
Trade payables 185/(368  200) × 28 360/(175+200) × 31
turnover = 31 days = 30 days
Trade payables 85/(368 200) × 365/12 360/(175+200) × 365/12
turnover = 33 days = 29 days

Page 6
 Subject CT2 (Finance and Financial Reporting) – April 2015 – Examiners’ Report

(ii) The £200,000 of sales at cost should be excluded from February’s turnover,
otherwise the directors will not be comparing like with like – January’s
percentage will be made up entirely of normal trading activity and February’s
will be a weighted average of trade sales and a major transaction with a zero
gross profit.

The £400,000 which has been paid for the new fixed asset should be excluded
from the bank overdraft. This will increase the bank balance to +£29,000.
This is because the liability is not really part of the normal overdraft and will
be replaced by a term loan.

(It might also be argued that the assets and liabilities relating to the “charity”
transaction should be excluded on the grounds that this is non-recurring and
has a distorting effect. The difference here is that the company does actually
have to finance these assets and settle the liabilities under normal trade
terms.)

(It might also be argued that the purchases figure can be best estimated by
adding the cost price of the charity sale to January’s cost of sales and
subtracting from February’s. The figures suggest that the company has built
up inventory in January in advance of this sale.

(iii) ROCE cannot really be calculated with any great accuracy for a period as
short as one month. The company might not make really accurate adjustments
for stocks as at the beginning and end of each month, monthly depreciation
charges, accruals and prepayments, etc.

If the company has any kind of annual business cycle then the directors might
get the mistaken impression that a month has been poor because of
fluctuations in return (as sales rise and fall) or capital employed (as net assets
change during the year).

While ROCE is the most important profit ratio, it is quite possible that it
would be far more sensible to concentrate on the secondary ratios such as
gross profit %, asset turnover, etc.. If these are maintained during the year
then the company should generate an acceptable return over the course of a
year.

Part (i) – this part was answered badly with many candidates failing to calculate the ratios
correctly which was disappointing. Even gross profit was problematic.
Part (ii) – unfortunately this part was answered badly with few candidates suggesting the
correct adjustments.
Part (iii) – candidates did not demonstrate much knowledge of ROCE. The comments tended
to be very basic and just commenting on it being a measure of profitability. As a result of this
the marks were quite low for this section of the question.

Page 7
 Subject CT2 (Finance and Financial Reporting) – April 2015 – Examiners’ Report

20 (i) Having two different people head the company offers a degree of mutual
oversight. The chairman and chief executive can be responsible for different
aspects of the management of the company.

The chairman and the part-time directors do not benefit when the company
reports higher profits and so they have no great incentive to misbehave. They
are likely to insist that the company is properly managed because their
reputations will be at risk for no purpose if they do not.

The full-time directors are all to receive profit-related bonuses. That will give
them an incentive to work in the best interests of the shareholders. The risk of
a repeat of the previous difficulties will be diminished because of the oversight
from the chairman and part-time directors.

The chairman and part-time directors can monitor the company’s activity for
lavish and unnecessary expenditure. They should have sufficient business
experience to realise the difference between legitimate expenses and
extravagances such as the limousines.

The fact that the full-time directors stand to share in a substantial shareholding
is a further incentive to work in the shareholders’ interests. These shares will
be far more valuable if the directors can work towards the maximisation of the
share price. The shareholders will, hopefully, have greater confidence because
of this. Furthermore, the three year vesting period provides the directors with
an incentive to settle with the company and offer continuity of management.
That period is also quite a long time in which to evaluate the directors’
competence and integrity.

Note: answers could refer to the requirements of the UK Code for Corporate
Governance or similar documents, but there was no need to do so in order to
obtain credit.

(ii) Given the problems with the overstated profits in the past it is clearly
undesirable to continue with the previous auditor. The shareholders
are unlikely to have a great deal of confidence in the outgoing firm.

A larger audit firm may be more credible. It has more to lose in terms
of its reputation and so the auditor may be less willing to compromise
over accounting issues

The fact that the audit fee is greater may also create the impression that
more work has been done or that the audit has been more thorough.
Shareholders may contrast the fee with that charged by the previous
auditor and may perceive the increase as an investment in higher
quality.

All auditors have the same professional qualifications and so there is

no guarantee that a bigger firm will necessarily provide a better quality
service. The higher cost of a bigger firm may not be justified in terms
of the actual assurance given.

Page 8
 Subject CT2 (Finance and Financial Reporting) – April 2015 – Examiners’ Report

Part (i) – this part was also answered quite badly. Candidates did not demonstrate
knowledge of corporate governance issues. However, many candidates gave good answers
about maximising shareholder wealth and confidence which helped increase the pass rate.
Part (ii) – answers to this part of the question were mixed. There were some very good
answers but also some poor ones.

END OF EXAMINERS’ REPORT

Page 9
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2014 examinations

Subject CT2 – Finance and Financial Reporting

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context at the date the
examination was set. Candidates should take into account the possibility that circumstances
may have changed if using these reports for revision.

F Layton
Chairman of the Board of Examiners

November 2014

 Institute and Faculty of Actuaries

 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2014 – Examiners’ Report

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 essay
type questions on these topics. The paper also examines financial reporting including
preparation of the main financial statements and interpretation of financial statements it also
considers the basis of the preparation of statements and the information needs of a variety of
end users of financial statements.

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

Comments on the September 2014 paper

The general performance was similar to results in the past, well-prepared candidates scored
well across the whole paper. As in previous diets, overseas candidates did not perform quite
so well as UK candidates. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Candidates approaching the
subject for the first time are advised to concentrate their revision in these areas. The main
problem was Q19, however many candidates scored high marks in all questions.

Page 2
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2014 – Examiners’ Report

1 B or C were accepted as correct answers [2]

2 C [2]
3 B [2]
4 C [2]
5 D [2]
6 B [2]
7 D [2]
8 A [2]
9 B [2]
10 D [2]

Workings

2 £0.03 = £0.25 – 0.22

£0.20 = premium
£0.23 = £0.25 + 0.20 – 0.22
£0.25 = nominal value

8 17.4% = 400,000/(1,000,000 + 800,000 + 500,000)

22.2% = 400,000/(1,000,000 + 800,000)
26.7% = 400,000/(1,000,000 + 500,000)
30.8% = 400,000/(800,000 + 500,000)

Questions 1–10 were done well by most candidates. No particular question caused a
problem for candidates.

11 Market prices are based on actual transactions, so market participants are actually
entering into transactions at these prices. Most quoted securities tend to trade quite
freely, so market prices are also likely to be quite up to date. The fact that these prices
are observable also means that they can be legitimated, unlike other valuations that
are likely to be based on models or opinions. The objectivity associated with market
prices means that they are likely to be acceptable to, say, tax authorities. [5]

This question was not specifically looking for a discussion of market efficiency, but an
answer based on the efficient markets hypothesis would be perfectly acceptable.

This question was done well by candidates.

Page 3
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2014 – Examiners’ Report

12 Non-recourse factoring is only worthwhile if an entity makes significant credit sales.

The entity will also be looking to release cash from its trade receivables, which
suggests that it might be in need of improving cash flows. Non-recourse factoring
usually involves a range of additional services, such as bookkeeping as well as credit
protection. There is very little point in paying for non-recourse factoring unless there
is a need for those services. The factor will only be willing to offer non-recourse
factoring if the customers are reasonably good credit risks. [5]

This question was done reasonably well by many candidates. The only problem was that
several candidates did not appear to understand the difference between factoring and non-
recourse factoring and their answer was therefore not clear.

13 Swap arrangements do not involve the actual exchange of liabilities. The two parties
usually arrange a net payment from one to the other, depending on the rates paid on
the variable rate liability. In the worst possible case, the party that is due to receive a
net payment will lose this amount because the counterparty defaults. The other risk is
that any default will leave both parties without the protection of fixed or variable rate
interest, which was the purpose of the swap in the first place. Both parties should take
the usual precautions of running credit checks. Sometimes the counterparty will be a
commercial bank rather than another business and so there will be a better basis for
trust. [5]

This question was done well by many candidates.

14 The expectation is that the scrip issue will be interpreted as a sign of confidence and
so the share price will increase. That only happens in practice because the directors
often maintain the dividend per share after a small scrip issue and so it might be
viewed as a signal that the board intends to increase dividends. Given that the
shareholders appear to lack confidence, they are unlikely to boost the share price just
because of a scrip issue.

The issue would dilute the existing share price, which could disrupt the share price.
Fresh shares cannot be issued for any less than the nominal value of £0.25 per share.
A significant scrip issue could leave the share price so close to the nominal value that
there is very little scope for offering the discount that is necessary to guarantee the
success of the issue. [5]

This question was done very well.

Page 4
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2014 – Examiners’ Report

15 Opportunity costs should be taken into account, particularly when projects are
mutually exclusive or there is capital rationing. When accepting one project means
that it would be impossible to proceed with another then the board should consider
whether the project under consideration is the best use of the entity’s funds.

Opportunity costs can be difficult to determine. It is necessary to identify all of the

alternative uses to which those funds can be applied or to identify all of the projects
that would be rendered redundant. It may be difficult for the managers who are
making the proposal to be aware of those implications, especially when the projects
are not directly drawn from the bidding department.

It may be a little naïve to expect the champions of one project to be clear and honest
about another project’s opportunities. [5]

This question was done well by many candidates.

16 Probability trees make it easy to determine the expected value of a complex project
that has various levels of decision that have to be taken. Different branches of the tree
will deal with the possibilities that were identified at the outset of the project and so
the decisions that will be appropriate at each stage of the project can be identified well
in advance and an appropriate direction selected. Decision trees generally offer a
clear and unambiguous solution to a potential problem.

On the other hand, expected values ignore the fact that many projects will not have an
“average” outcome. For example, a decision tree might suggest that a project has a
very small positive expected value when the actual outcome will either be a large
profit or a large loss. [5]

This question was done reasonably well by most candidates.

17 The external auditor offers an opinion on the fair presentation/truth and fairness of the
financial statements. That gives the shareholders the reassurance that the figures have
not been manipulated or distorted in a manner that would make them misleading. The
audit opinion is based on the collection of evidence on the accuracy of the
bookkeeping records. Auditors are qualified accountants who are experts in financial
reporting matters. The auditor’s reputation will be impaired if an invalid or
unsupported opinion is offered. [5]

This question was not done as well as expected. In general many answers were vague and
did not answer what was asked in much detail.

Page 5
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2014 – Examiners’ Report

18 The upside risk is that very little cash will be tied up in working capital. Cash flows
will be rapid and so the entity should be reasonably sound in terms of liquidity.

Reducing inventory can be achieved through careful management and monitoring.

Such an approach creates a cost in terms of the time spent managing inventory and
also having to incur ordering costs from placing a larger number of smaller orders.
The alternative is that the entity simply runs inventory down to such a low level that it
runs out, possibly losing sales and disrupting operations. Reducing receivables
usually requires pressing for rapid payment, which may also reduce demand if
customers are keen to obtain a more lenient set of credit terms. [5]

This question was done well by many candidates. The main problem with candidates who did
less well was a failure to discuss inventory in any detail.

19 (i) Debt has the advantage of interest payments being tax deductible. Lenders
usually have quite a lot of security, so they charge a reasonably low rate.

This business may make many lenders nervous. It is a new venture that may
not prove successful because it is selling a niche product that is untried in the
UK. The assets will be in the form of inventories of products that could be
difficult to sell quickly in the event of a foreclosure.

In the event that the business succeeds it may find cash flows problematic.
Imports are likely to be for cash and sales are likely to be on credit, which will
stretch working capital and that may make it difficult to service debt.

Equity will be relatively expensive because potential investors may be nervous

about the business plan. They may require a considerable percentage of the
equity to make the risk worthwhile. Trevor and Simone may find it difficult to
retain full control if they wish to attract investors.

The fact that the founders wish to retire for good in the medium term future
may deter many potential investors. If the business succeeds then the other
shareholders may be unable to raise sufficient cash to buy Trevor and Simone
out and so they may be faced with the loss of control to a new set of investors.
[10]

(ii) There is likely to be an optimal level of gearing because our two founders are
unlikely to be able to create their own gearing, which is the basis of the MM
irrelevance argument. Ideally, the gearing level should be sufficient to get the
best of the lower gross cost and the tax relief compared to the higher cost of
equity.

Trevor and Simone will be relatively risk averse because their life savings are
being invested in this business. They cannot really afford to risk liquidating
the business in order to settle overdue loan repayments. That suggests that
benchmarks, such as the gearing ratios of similar businesses in the same line
may not be particularly appropriate.

Page 6
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2014 – Examiners’ Report

The fact that this is a new business that is selling products that are, by
definition, unproven makes it more difficult to predict the cash flows from
which debt can be serviced. The founders must also allow some of their debt
capacity to remain unused so that they have a source of cash to deal with
emergencies. They do not have any cash of their own left over in order to
inject further equity.

Lenders may offer guidelines as to the maximum that they will be prepared to
advance, but that does not help Trevor and Simone because the lenders will be
banking on the protection offered by the buffer of the founders’ equity.

The fact that there are only two principal decision-makers also complicates
matters. Trevor and Simone may have different risk tolerances and each may
have a different view about the ideal level of gearing.
[10]
[Total 20]

This question was unfortunately done very badly by a number of candidates. Candidates
struggled to say much about debt and equity and financing and then candidates did not write
much at all about gearing. Many candidates did not understand that having two decision
makers complicated the situation. Candidates did not think through what they had learned
and apply it to this particular scenario successfully so many did not do well in this question.

The problem seemed to be that applying knowledge to this scenario was difficult for
candidates.

Page 7
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2014 – Examiners’ Report

20 Victor Ltd
Income Statement for the year ended 31 August 2014

Revenue 108,000
Cost of sales (62,011)
Gross profit 45,989
Selling and distribution (12,387)
Administrative expenses (10,267)
Operating profit 23,335
Finance charge (3,480)
Profit before tax 19,855
Tax expense (4,190)
Profit for the year 15,665

Victor Ltd
Statement of Changes in Equity for the year ended 31 August 2014

Equity Retained Total

shares earnings
£000 £000 £000
Opening balance 60,480 23,760 84,240
Profit for the year 15,665 15,665
Dividend (3,240) (3,240)
Closing balance 60,480 36,185 96,665

Page 8
Subject CT2 (Finance and Financial Reporting Core Technical) – September 2014 – Examiners’ Report

Victor Ltd
Statement of Financial Position as at 31 August 2014

£000

Non-current assets 127,861

Current assets
Inventory 675
Trade receivables 9,072
Prepayment 10
Cash 11,340
21,097
Total assets 148,958

Equity
Share capital 60,480
Retained earnings 36,185
96,665

Non-current liabilities
Debentures 43,470

Current liabilities
Trade payables 2,844
Accruals 1,789
Tax payable 4,190
8,823
148,958

Note: Non-current assets

Page 9
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2014 – Examiners’ Report

Factory Property, Total

plant and
equipment
£000 £000 £000

Cost 100,440 90,504 190,944

Depreciation
Opening balance 19,008 25,920 44,928
Charge for year 2,009 16,146 18,155
Closing balance 21,017 42,066 63,083
Net book value 79,423 48,438 127,861

Workings

Cost of sales
Opening inventory 2,160
Manufacturing overheads 3,606
Purchases 27,000
Wages – manufacturing 11,772
Closing inventory (675)
Factory depreciation 2,009
Equipment depreciation 16,146
Accrued wages 3
Prepaid insurance (10)
62,011

Selling and distribution

Wages 12,384
Accrued wages 3
12,387

Administrative expenses
Trial balance 4,500
Audit fee 3,780
Wages 1,944
Accrued wages 3
Accrual 40
10,267

Accruals
Wages 9
Administration 40
Accrued interest 1,740
1,789
[20]
Question 20 was done really well by most candidates. This contributed to the very good pass
rate for this diet. It was evident that candidates had spent time learning this topic and it paid
dividends as the marks were very high for this question.
END OF EXAMINERS’ REPORT

Page 10
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2014 examinations

Subject CT2 – Finance and Financial Reporting

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

D C Bowie
Chairman of the Board of Examiners

June 2014

© Institute and Faculty of Actuaries

 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2014 – Examiners’ Report

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 essay
type questions on these topics. The paper also examines financial reporting including
preparation of the main financial statements and interpretation of financial statements it also
considers the basis of the preparation of statements and the information needs of a variety of
end users of financial statements.

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

Comments on the April 2014 paper

The general performance was similar to results in the past; well-prepared candidates scored
well across the whole paper. As in previous diets, overseas candidates did not perform quite
so well as UK candidates. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Candidates are advised to include
these areas in their revision. The main problems were Q19 and 20; however many candidates
scored high marks in all questions.
 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2014 – Examiners’ Report

1 A
2 C
3 B
4 C
5 D
6 D
7 C
8 B
9 C
10 C

6 11.6% = (17 × 10/25) + (8 × 15/25)

14% = (17 × 30/45) + (8 × 15/45)
14.27% = (17 × 30/45) + (7 × 15/45)
14.55% = (17 × 48/66) + (8 × 18/66)

8 £1.8m = 30% × £6m

£2.4m = 30% × £8m

9 €150,000 = €950,000 – 850,000

€200,000 = cancelled depreciation
€350,000 = €950,000 – (800,000 – 200,000)
€750,000 = €950,000 – 750,000

Generally questions 1–10 were answered reasonably well by most candidates.

11 The value of the debt will depend on the likelihood that the company will meet its
commitments to pay the interest and the capital. The decline in the equity shows that
the market believes that the company is less profitable. That loss appears to have
been borne by the shareholders only, whose equity acts as a safeguard to protect the
lenders. The shareholders are entitled to all residual profits and so any setback will
affect their future cash flows. The lenders do not receive any benefit from the entity’s
profit, at best they will receive their agreed payments on time. Thus, the lenders are
not necessarily affected in the same way as the shareholders.

The lenders may have taken care to impose an upper limit on borrowing so that there
is very little realistic probability of their repayments being affected .

This question was not done especially well. Some answers were very confused and it was not
clear exactly what was meant in their answer. Some candidates did not discuss the lenders at
all.

Page 3
 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2014 – Examiners’ Report

12 Ron will be able to buy the shares at a discount and resell them immediately for their
full market price.

If Ron invests in his employer then he may be motivated and take a greater interest in
his work.

It sounds as if Ron may not have a properly diversified portfolio. The markets will
not reward him for retaining the diversifiable unsystematic risks. Furthermore, in the
event that the company declines Ron may lose both his job and his investment, so he
is even more exposed to the company’s performance.

Ron may be better placed as an employee to determine whether Global is performing

well and so he may be able to mitigate these risks by being sufficiently well informed
to sell before information becomes generally available. The observations of
individual employees are unlikely to comprise insider trading.

This question was done very well by many candidates.

13 It would be impractical to permit depreciation as a taxable expense because of the

discretion that is available in estimating the charge. The owner could easily
manipulate depreciation in order to reduce profits or avoid making large tax losses.
The tax authorities would be unable to do very much to prevent such behaviour
provided the rates being used for depreciation could be justified.

It is incorrect to say that no benefit is given. UK tax law gives a capital allowance in
lieu of depreciation. Capital allowances are essentially just depreciation that has been
determined in a very consistent and systematic manner.

This question had a mixed response from candidates with many candidates failing to mention
capital allowances or the possibility of manipulating depreciation.

14 Seven shares held before the issue will be worth 7 × £5.20 = £36.40.

The new project will increase market capitalisation by 20%, so seven shares will
increase in value to £36.40 + 20% = £43.68.

The cash injection will add a further £4.50 per seven shares
= £43.68 + £4.50 = £48.18.

Each share will be worth £48.18/8 = £6.02.

This question was done well by many candidates.

Page 4
 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2014 – Examiners’ Report

15 The scrip issue offers the investor a choice between £0.50 cash and
2 × £2.70/9 = £0.60 of equity. At face value, the scrip dividend appears more value,
although there will be some dilution. Transaction costs will probably mean that it is
not cost-effective to take the scrip dividend with a view to the immediate resale of the
shares.

The investor will have to pay tax on the scrip dividend but there is no cash coming in
and so this will have to be settled out of existing cash balances.
The shareholder will have to consider whether the scrip issue will leave the portfolio
unbalanced.

This question was done well by many candidates.

16 Very few assets have free and transparent markets that make it possible to observe fair
values. Fair values generally require subjective decisions, perhaps based on
transactions that are not necessarily indicative of the values that would be obtained for
a particular asset. For example, the fair value of an office block could be estimated
using selling prices for similar offices in similar locations, but those will not
necessarily establish the actual price that will be obtained for a specific building.
Transactions used for comparison may be slightly out of date. Comparisons may be
based on transactions that are not at arm’s length.

Ultimately, an asset’s fair value can only be established by actually putting the asset
up for sale and waiting until a firm offer to buy it has been received.

This question had a mixed response. Some candidates did this well and others badly.
Application of knowledge seemed to be the main problem.

17 The IASB develops high quality accounting standards (IFRS). IFRS provide a basis
for comparison between companies, with consistent treatments of similar items.
Thus, the IASB promotes confidence in the financial statements.

The IASB also demonstrates the accountancy profession’s commitment to ensuring

high quality accounting statements. There have been issues in the past with concerns
about accounting scandals and the IASB’s existence is clear evidence that such
behaviour cannot be tolerated.

The IASB’s standards facilitate global investment and trading.

This question was done well by many candidates.

Page 5
 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2014 – Examiners’ Report

18 The going concern concept effectively requires consideration of the long-term future.
A company’s ability to survive may depend on many different factors, each of which
is very difficult to predict. For example, the market for the entity’s products could
decline or there could be a problem with cash flows and the availability of finance to
deal with that.

Another difficulty is that preparers will only ever be challenged when the company
has actually run into difficulties. Users of financial statements may claim that the
going concern status was inappropriate on the basis of actual outcomes rather than
expectations based on the information that was available at the time. Many users,
such as buyers, will place a great deal of emphasis on going concern.

This question was done very badly by most candidates. Candidates could briefly quote what
the going concern concept was but then stopped. There was a lack of ability to apply
knowledge from the core reading to a question.

19 (i) EBITDA = 58.2 + 62.0 + 40.0 = £160.2m

Analysts are generally concerned that any subjective decisions will be used to
manipulate the financial statements. The figure for EBITDA excludes two of
the biggest sources of subjectivity in the financial statements: depreciation and
amortisation.

It may be difficult to restate figures to make these comparable. For example,

Lomax’s accounting policy on depreciation does not make it possible to
establish whether the company is more or less conservative than similar
businesses.
Analysts prefer pre-tax figures because those are generally more comparable
with other income sources, and it avoids the subjective estimate of the tax
liability.

(ii) Book value of rights 360,000,000

Amortisation based on 15 years 24,000,000
Increase in earnings 16,000,000

Revised earnings attributable to the shareholders 49,500,000

Revised EPS 0.99

Expected share price based on present 10.72

Expected share price based on revised 15.84

We are assuming the straight line basis for the amortisation of the intangible.

We are assuming that the P/E ratio of 16 is robust and that the market will
multiply the earnings figures by 16.

We are assuming that the P/E ratio will not change during the period from 31
March 2014 until the date when the financial statements will be published.

Page 6
 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2014 – Examiners’ Report

That assumption implies, further, that nothing in the financial statements

themselves will affect the market’s view of future cash flows.

(iii) The share price is determined in terms of future cash flows. The amortisation
of an intangible asset is not a cash flow and so the figure has no direct
relevance to determining the share price.

The capital markets might be influenced by the information implied by

management estimates. Extending the projected life of the asset may imply
that additional costs will not be incurred in developing new products and so
the share price might increase.

The capital markets might interpret these changes as evidence that Lomax’s
directors feel that it is necessary to overstate accounting profits. That might
lead to a decrease in confidence and a decline in the share price.

Part (i) – This question was not done very well, many candidates could attempt the
calculation but did not answer the written part well. It seems that candidates have the
knowledge from the core reading but have difficulty applying it in some of these questions.

Part (ii) – This part of the question was done reasonably well by some candidates but many
candidates did not achieve a high mark in this section of the question.

The calculation was done quite well by a number of candidates but many candidates did not
state their assumptions.

Part (iii) – This part of the question was done badly as candidates could not apply the
knowledge learned from the core reading material.

20 (i)

Year ended Year Year ended

30 June ended 30 30 June
2015 June 2016 2017
£ £ £
Revenue 40,000 50,000 60,000
Fuel, boat repairs (14,000) (17,500) (21,000)
and mooring
Working capital (2,000) 2,000
24,000 32,500 41,000
Sally's share 12,000 16,250 20,500
Discount factor 0.893 0.797 0.712
PV 10,716 12,951 14,596 38,263

The net present value of Sally’s cash flows = £38,263 – 21,000 = £17,263

Sally should accept this project on a net present value basis. This is a major
investment for her, though, and so it may not be appropriate to risk such an
amount.

Page 7
 Subject CT2 (Finance and Financial Reporting Core Technical) – April 2014 – Examiners’ Report

(ii) The first step would be for Sally to estimate how much she would accept as a
guaranteed sum in place of each of the cash flows in her forecast. For
example, she anticipates a cash inflow of £12,000 at the end of year 1. That
amount is subject to the risks associated with the running of the business and
so it would be logical for her to accept less in return for a guarantee that the
lesser sum would be paid. The estimates that she uses will be highly
subjective and they really have to be decided by her, although she might start
by considering the likely ranges of outcomes and taking those into account.
She might also consider her need for cash inflows at each of those dates.

Once she has determined the certainty equivalents then they should be
discounted at a risk-free rate. The 12% rate includes an element to
compensate for the risks attached to the project.

S (iii) Tom is clearly attempting to make the project appear more attractive so that
Sally will invest.

This project involves Sally risking a significant part of her wealth, more than
she can afford to lose. She needs to evaluate the risk on the basis that the
change in the law might lead to the boat being scrapped as worthless before
she has received any revenue from the project. She should actually decide on
the basis of a discount rate that ignores the possibility of the change in the law.
She should then make a subjective decision as to whether that revised net
present value is sufficient incentive to risk the loss of her savings.

It might be appropriate to adjust the discount rate for a decision maker who
has a large number of projects to consider. That would mean that the “all or
nothing” aspect of these risks would not apply because of the portfolio effect.

Part (i) – This question was done badly with very few candidates making a good attempt.

Part (ii) – This part of the question was done very badly. Very few candidates made a
reasonable attempt at this question and many missed it out. Those who did attempt the
question found it very difficult to clearly express an answer and even more just wrote a brief
explanation of certainty equivalents. It is important to think of application of knowledge when
revising.

Part (iii) – Unfortunately this part of the question was not done well. Again it seems to be an
area where candidates found it difficult to apply knowledge learned from the core reading.

END OF EXAMINERS’ REPORT

Page 8
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2013 examinations

Subject CT2 – Finance and Financial Reporting

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

D C Bowie
Chairman of the Board of Examiners

December 2013

 Institute and Faculty of Actuaries

 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

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 essay
type questions on these topics. The paper also examines financial reporting including
preparation of the main financial statements and interpretation of financial statements it also
considers the basis of the preparation of statements and the information needs of a variety of
end users of financial statements.

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

Comments on the September 2013 paper

The general performance was similar to results in the past, well-prepared candidates scored
well across the whole paper. As in previous diets, overseas candidates did not perform quite
so well as UK candidates. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Candidates approaching the
subject for the first time are advised to include these areas in their revision. The main
problems were Q19 and 20, although many candidates scored high marks in all questions.

Page 2
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

1 C
2 B
3 D
4 D
5 C
6 A
7 D
8 B
9 C
10 B

Workings for Question 5

A = (40  8)/(200 + 300 + 22) = 6.1%

B = (40  8)/(200 + 300) = 6.4%
C = 40/(200 + 300 + 22) = 7.7%
D = 40/(200 + 300) = 8.0%

Questions 1–10 were done well by most candidates.

11 The LLP structure protects the members from claims against their personal wealth.
The LLP is a separate legal entity and its creditors cannot pursue the partners if the
LLP’s assets prove insufficient. That is a significant advantage because the partners in
a traditional partnership are jointly and severally liable in a personal capacity. The
actions of one partner could impose enormous personal liabilities on all of the others.
The only real exception is when an individual partner behaves recklessly or
dishonestly. In that case he or she may be personally liable to compensate any injured
party.

This question was done well by most candidates.

12 Dividend policies tend to attract shareholders on the basis of their tax preferences. A
company that pays little or no dividends will attract shareholders who prefer to
receive capital gains. A share buyback would possibly leave the shareholders open to
a claim for capital gains tax, but the funds released would not be income. There is a
further issue with respect to signalling. The buyback does not imply that future
dividends will be increased and so there is no question of misleading and
inconvenient signals being sent to the shareholders.

This question was done reasonably well by most candidates.

Page 3
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

13 The investor’s portfolio is not properly diversified. The capital markets do not offer
any return for accepting unsystematic risks because they can be diversified away. This
investor has accepted the risks borne by the oil and gas industry, but there will be no
benefit in the form of a higher return for this risk. The portfolio offers some
geographical diversification, but even that will be restricted to the countries that have
quoted oil or gas companies. This policy is only sound if she can genuinely identify
mispriced securities in this industry. Such an investment strategy is speculative.

There were some very good answers by candidates to this question.

14 One problem is in determining a value for those benefits. In some cases that could be
linked to the costs involved. For example, providing access to a company gym could
be viewed as a fringe benefit, but it will be very difficult to measure the value
obtained. This can lead to complicated arrangements, such as those relating to the
personal use of company cars in the UK, where records have to be maintained and the
tax authorities have to dictate the basis upon which the benefit should be provided.

There will be compliance problems because it may be difficult to maintain adequate

records of all of the benefits enjoyed by each of the employees.

There may also be motivational issues, if employees do not perceive the full value of
the benefit, but do see a cost in the form of a higher tax charge.

This question was not done very well by some candidates. In general candidates found it
difficult to write more than a short sentence or two. Benefits in kind are an important part of
the tax system.

15 Strictly speaking, the acceptance of a positive NPV project should increase the share
price. That will only be the case if the acceptance of the project is known and
understood and the shareholders agree with the directors’ evaluation. The company
may not wish to furnish the markets with details of this project for fear of attracting
competition. If the directors make an unsupported statement that profits are expected
to rise then the shareholders may dismiss that as self-serving disclosure by the board.
The decline in profits and cash flows in the short term will be observable and those
may affect the share price.

This question was answered well by many candidates. The link between positive NPV, share
price and the problems of disclosure was discussed reasonably well.

16 The comparison of the opening and closing balances can reveal a net cash inflow or
outflow, but cannot show the reasons for that change. A cash flow statement provides
the reader with details of the extent to which the operating activities are generating (or
consuming) cash. The cash flow statement also shows the other cash flows, broken
down into relevant categories. Thus, the cash flow statement can highlight the fact
that a net cash inflow occurred because the company has raised fresh borrowings. The
statement can also show how that cash inflow was applied. The cash flow statement

Page 4
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

makes it easier to reveal whether the net movement was attributable to the working
out of a business strategy (e.g. the deliberate investment of surplus cash) or the first
sign of a problem (e.g. cash flow problems).

This question was answered very well.

17 The basic problem with this case is the decision as to when a profit has been earned.
The realisation concept would suggest that the sale of a policy is a significant part of
recognition. The company would not sell insurance if doing so was unprofitable.
Prudence would suggest that no profit be recognised on an insurance contract until
such time as the company knows whether or not there will be a claim, which is likely
to be shortly after the customer’s safe return. The accruals concept suggests that it
would be ideal if the costs could be recognised in the same period as the revenue. The
easiest way to do that would be to wait until after the date of travel. It could be
possible to estimate the costs of potential claims and create a provision at the time of
sale. The money measurement concept would make that feasible if the estimate was
deemed to be reasonably accurate.

This question was answered reasonably well by many candidates.

18 Groups of companies are not legal entities as such and so it is impossible to have a
direct relationship with a group. Alpha’s relationship will be with one group member,
Global. Alpha cannot take it for granted that Mega will support Global in the event
that it runs into difficulties and finds itself incapable of meeting its commitments. It
may be of some comfort to know that Global is part of a large group because it may
not be in Mega’s interest to permit Global to fail. If Alpha really intends to rely on
that possibility then it should seek written assurances that Mega will guarantee
Global’s future.

This question was not answered as well as expected.

19 (i) Paul will have the advantage of equity finance. The venture capitalist cannot
demand repayment in the event of short-lived cash flow problems. Paul may
also be able to request further financial support from the venture capitalist in
the event of any unforeseen contingencies. The venture capitalist has an
incentive to support the business because of the prospect of the capital gain in
the event of it being a success.

Paul will also benefit from the provision of an experienced director, who will
provide advice to the business while it is growing. That will leave Paul free to
work on developing and marketing the product.

The venture capitalist has the opportunity to make a substantial return if this
product proves a success. The cost of acquiring this right is linked to the cost
of setting up initial manufacturing and so it may not reflect the full value of
the product’s patent.

Page 5
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

Paul will be committed to this business, partly because of the contract and
partly because of the right to buy back the equity. The venture capitalist would
probably find it difficult to attract such an entrepreneur without offering an
equity stake in this manner.

This is a risky investment, but the downside is restricted to the initial

investment and there is a very substantial upside.

This question was answered very badly by several candidates. A lack of knowledge of this
subject area was demonstrated.

(ii) Both parties will be at odds with one another over the valuation. Both will
wish to influence the independent valuer, who will have to draw upon
internally generated information and reports in order to undertake this
valuation exercise.

Paul may indulge in dysfunctional behaviour in order to lower the valuation in

the lead-up to the valuation date. New products in development may not be
revealed or may be made to look unprofitable.

The basic problem is that there will be no independent basis for the valuation
of the company. The lack of a market price means that the valuation exercise
will be highly subjective. There are likely to be a variety of different valuation
models and each will provide a different figure.

This part was done reasonably well.

(iii) One approach would be to identify one or more quoted companies that are
innovators in product design in the same area as this business. These
companies’ price/earnings ratios will be a matter of record. The business’
latest reported profit figure could then be multiplied by this comparator’s P/E
to give an estimated valuation.

The benefit of this approach is that it links valuation to profits and earnings,
which appears to be the focus of the business. It relates the value of the shares
to the most recent results of the business. It may be necessary to adjust profit
to allow for the possibility that there have been unusual transactions or that
there is a clear expectation of future growth.

Any valid alternative approach would be awarded credit.

This part of the question was poor with candidates finding it difficult to think of anything to
discuss.

Page 6
 Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

20 (i)
June July August

Current ratio 1.5 1.8 2.3

Event company receivable turnover (days) 15 28 33
Credit card receivable turnover (days) 45 49 53
Inventory turnover (days) 26 26 26

Trent’s current ratio actually looks healthy. The problem is the composition of
current assets. The event company owes Trent a great deal of money. That
appears as a current asset, but recovery times are slowing dramatically. Trent
is also very exposed to the failure of the company’s one credit customer.

The credit card company is also slowing down its payments to Trent. That is a
further reason for the net outflow of cash.

Inventory turnover continues from month to month at a steady pace and the
increase in inventory holdings is in line with production.

The overdraft is a major cause for concern because it is potentially repayable

on demand. Trent could easily find itself totally insolvent if it does not
improve its cash management.

The calculations of the ratios was done well by candidates the discussion was done less well.

(ii) The first question is whether it would be possible to press the event company
for more rapid payment. It looks as if the whole of August’s sales remain
unpaid. It may even be worth risking the loss of the company’s business if
Trent is going to wait so long for payment that overdraft interest swamps the
profit.

Trent should also press the credit card company. It may be easier to threaten to
move to another provider of this service.

It does not look as if matters are deteriorating with respect to inventory, but
running inventory down to less than 26 days’ holding would release cash.
Once there is greater clarity about the payment stream from both receivables,
Trent should consider raising finance to support the cash flow until the bank
account is back in credit. That may be a matter of negotiating a larger
overdraft or taking out a short-term loan. Even if the payables cannot be
collected any more quickly, matters will improve when the expansion ceases
and sales and cash flows settle to a steady equilibrium.

This part was done reasonably well.

END OF EXAMINERS’ REPORT

Page 7
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2013 examinations

Subject CT2 – Finance and Financial Reporting

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

D C Bowie
Chairman of the Board of Examiners

July 2013

© Institute and Faculty of Actuaries

 Subject CT2 (Finance and Financial Reporting) – April 2013 – Examiners’ Report

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 essay
type questions on these topics. The paper also examines financial reporting including
preparation of the main financial statements and interpretation of financial statements it also
considers the basis of the preparation of statements and the information needs of a variety of
end users of financial statements.

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

Comments on the April 2013 paper

The general performance was slightly improved than in September 2012 well-prepared
candidates scored well across the whole paper. The comments that follow the questions
concentrate on areas where candidates could have improved their performance. Candidates
approaching the subject for the first time are advised to include revision of these areas in their
preparation. The main problems were Q19 and 20; however many candidates scored
excellent marks in all questions.

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 Subject CT2 (Finance and Financial Reporting) – April 2013 – Examiners’ Report

1 B
2 D
3 B
4 C
5 A
6 D
7 B
8 A
9 D
10 D

None of the multiple choice questions caused problems and the marks were good for
questions 1–10.

11 Companies should take the effect of tax into account when determining the cost of
finance. Most companies will find that debt reduces taxable profit, which will also
reduce the cost of debt compared to equity. If the company is making losses then the
use of debt will simply increase the loss for tax purposes and so there will be no tax
benefit.

It may be that losses can be carried forward and offset against future taxable profits,
so that should be considered as part of the overall analysis.

Perceptions could also be important. If the directors act in a manner that suggests
they do not see a return to profit in the foreseeable future then the shareholders may
view that as a lack of confidence.

The tax effects of certain borrowing schemes can be relevant even to loss making
companies. For example, lessors can often claim the tax benefits associated with
buying assets into account in setting lease payments. Those can be passed on to
the borrower in the form of a lower lease payment.

The answers to this question were weaker than for many others. Many candidates did not
seem to know much about taxation and why it might be considered in financing decisions.

12 The first risk is that Sarah could lose everything. As a partner she will not be
reimbursed her capital in the event of failure unless all of the creditors have been paid
in full.

If the business makes a loss then her capital will be eroded.

In the event that she finds Tom difficult to work with she will have to either persuade
him to buy her stake or she will have to have his agreement to sell her stake to a third
party. In any case, it may be difficult to find an interested potential buyer.

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 Subject CT2 (Finance and Financial Reporting) – April 2013 – Examiners’ Report

Sarah’s liability will be joint and several. She will be liable for all of the debts
incurred by the business, not just the 30% implied by her stake. Creditors could
pursue her personal property in the event that they are left unpaid.

There were some excellent answers to this question.

13 From a financial point of view, the issue of redeemable preference shares may be very
similar to issuing debt. The directors will be able to suspend the preference dividend
in the event that they could not afford to pay it so there is a little more flexibility than
borrowing. However, there will be a penalty, almost certainly involving the
suspension of the ordinary dividend while the preference dividend remains unpaid.

The rate of preference dividend is fixed, which means that the impact on the volatility
of earnings per share is equivalent to making fixed interest payments. In some ways,
preference shares may be worse because the preference shareholder will want a
significant rate of dividend to account for the risk that is being taken relative to
lending.

The redemption of the share imposes exactly the same financial burden as a loan that
is to be repaid in a lump sum at the end of the loan period.

Candidates will be awarded marks if they write about the accounting treatment of
redeemable preference shares as set out in IAS 32.
Candidates were slightly weak at this question. There were few very good answers.
There seemed to be a general lack of understanding of this topic.

14 The definition of an asset hinges on the question of control. That can sometimes be
distinguished on the basis of holding the risks and rewards of ownership. The nature
of a finance lease is that the lessee enjoys the risks and rewards of ownership because
the lease grants the lessee the use of the asset for most or even all of the asset’s
expected useful life.

If the asset is recognised in the financial statements then it will be necessary to show
the associated liability arising from the lease. If the lessor has purchased the asset
for the lessee’s exclusive use then it follows that the lessee must be committed to
repaying the value of that asset through the lease payments.

Legal ownership is not a material element of the definitions of assets or liabilities.

This question was done very well by most candidates.

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 Subject CT2 (Finance and Financial Reporting) – April 2013 – Examiners’ Report

15 The swap itself may lead to a negative net present value. Presumably, the company
signed the swap in the expectation that interest rates will fall, in which case, the swap
would effectively lower the cost of borrowing. If rates rise then the swap will cost the
company money.

The two parties do not actually exchange their commitments, so the failure by the
counterparty would not leave the company committed to both sets of payments.
The default of the counterparty could leave the company with an uncollectable
receivable if the cash flows were in the company’s favour.

The counterparty may be at risk in either scenario. If rates fall then the counterparty
may be at a commercial disadvantage to competitors with floating rate liabilities, who
can pass the reduction in interest rates on to customers in the form of lower prices. If
rates rise then the counterparty’s customers may reduce their spending in response.

This question had some very mixed answers; some candidates did very well and others lacked
understanding of swaps.

16 Simulation is an excellent way to deal with complicated projects where there are
many interactions between variables. The success or otherwise of this investment will
be affected by the economy and demand for power. Fuel prices will affect the cost of
conventional power generation and the ability of the competition to undercut wind
power. Those factors may affect costs such as interest (e.g. higher energy prices will
increase inflation and so boost interest rates).

Simulation will make it possible to model such links in a detailed manner and to run
the model frequently until an equilibrium is reached. This can be combined with
unrelated variables, such as the weather – which will again affect demand and also the
ability of wind power to generate electricity.

This question was done very well by most candidates. This question has been asked in a
slightly different format in previous diets and it was not surprising that it was done well.

17 In the worst possible case the directors will create the risks associated with borrowing
without any corresponding disclosures. That could lead to shares being purchased
and sold at inflated prices. It could also lead to shareholders accepting risks that they
would normally refuse.

The company could fail unexpectedly if it fails to keep up with the commitments
imposed by this arrangement.

The shareholders are likely to suffer greater borrowing costs than would arise from
traditional loans. The investment banks tend to charge a fee for their services in
providing this type of arrangement.

Many candidates did this question well.

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 Subject CT2 (Finance and Financial Reporting) – April 2013 – Examiners’ Report

18 The statement of financial position shows a snapshot of liquidity at a point in time.

The figures are determined annually at the same time of year. That may give an
insight into changes, but it also ignores the possibility that the year-end position is at
the very end of the annual business cycle and is not representative of the year as a
whole.

The liquidity position can be distorted by window-dressing and so it may understate

any liquidity risks.

The statements are not published immediately after the year end and so there could
have been a massive change in the liquidity picture since the year end. The company
could have looked solvent six weeks ago but that could mean very little with respect
to current trade payables.

This question was done extremely well.

19 (a)
Holder
Income statement
for the year ended 31 March 2013

£000

Revenue 1,686,000
Cost of sales (782,200)
Gross profit 903,800
Administration expenses (3,600)
Distribution costs (231,000)
669,200
Interest paid (38,400)
Profit for year 630,800

(b)
Holder
Statement of changes in equity
for the year ended 31 March 2013

Share Revaluation Retained Total

capital reserve earnings
£000 £000 £000

Opening balance 210,000 240,000 262,350 712,350

Revaluation 255,000 255,000
Profit for year 630,800 630,800
Dividends (150,000) (150,000)
Closing balance 210,000 495,000 743,150 1,448,150

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 Subject CT2 (Finance and Financial Reporting) – April 2013 – Examiners’ Report

(c)
Holder
Statement of financial position
as at 31 March 2013

Notes £000

Non-current assets
Property, plant and equipment (1) 1,644,800

Current Assets
Inventory 36,000
Trade receivables 126,000
162,000
Total assets 1,806,800

Equity and liabilities

Equity
Share capital 210,000
Revaluation reserve 495,000
Retained earnings 743,150
1,448,150

Non-current liability
Loan 300,000

Current liabilities
Trade payables 57,000
Bank 1,650
58,650
1,806,800

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 Subject CT2 (Finance and Financial Reporting) – April 2013 – Examiners’ Report

Notes

(1) Property, plant and equipment

Cost or valuation Land Buildings Machinery Vehicles Total

£000 £000 £000 £000 £000

Opening balance 840,000 450,000 186,000 375,000 1,851,000

Revaluation 160,000 50,000 210,000
Closing balance 1,000,000 500,000 186,000 375,000 2,061,000

Depreciation
£000 £000 £000 £000 £000

Opening balance 45,000 84,000 255,000 384,000

Revaluation (45,000) (45,000)
Charge for year 10,000 37,200 30,000 77,200
10,000 121,200 285,000 416,200
Net book value 1,000,000 490,000 64,800 90,000 1,644,800

Workings

Cost of sales
cost of inventory consumed 435,000
factory running costs 105,000
manufacturing wages 195,000
depreciation of buildings 10,000
depreciation of machinery 37,200
782,200

Distribution
advertising 66,000
delivery vehicle running costs 51,000
sales salaries 84,000
depreciation of vehicles 30,000
231,000

Candidates generally demonstrated a good understanding of the basic issues of accounts

preparation. There were some excellent attempts at this question but also some very weak
attempts.
There are many places that errors can occur and it is very easy to make careless mistakes.

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 Subject CT2 (Finance and Financial Reporting) – April 2013 – Examiners’ Report

20 (i) Geared beta = ungeared beta × (1 + debt:equity ratio × (1 − tax rate))

= 1.3 × (1 + 220/600 × (1 − 0.23))
= 1.667

ke = 4 + (1.667 × (9 − 4))
= 12.335

(ii) Coupon payment on debt = 250 × 5% = 12.5

NPV of debt at 6% = −220 + (12.5 × 4.212) + (250 × 0.747) = 19.4

NPV of debt at 10% = −220 + (12.5 × 3.791) + (250 × 0.621) = −17.36

Yield is approximately half way between 6% and 10% = 8% (to nearest

whole %)

kd = 8% × (1 – 0.23) = 6.16

(iii) WACC = (220/(220 + 600) × 6.16) + (600/(220 + 600) × 12.335) = 10.678%

(iv) It is very unlikely that the capital markets will be swayed by promotional
material that simply describes Partan in a positive way. Advertising can create
an emotional response to a product, but that is unlikely to be effective in the
development of a company’s financial instruments. Market participants will
be keen to see evidence that the company can generate a cash surplus and have
already formed a view on the extent to which that will happen. The
information that is already in the public domain will have been incorporated
into the share price and simply restating that information in the form of a sales
promotion is unlikely to change anything.

It is possible that the directors will have a more positive view on the
company’s prospects because they have inside knowledge and will be better
informed. It may be that they can communicate some of that additional
information in order to correct any under-pricing. If the markets believe the
directors then the cost of capital may be re-evaluated and reduced.

The fact that the directors have an incentive to argue for a lower cost of capital
may mean that the shareholders will be suspicious of this initiative. The
directors will almost certainly have to release commercially sensitive
information that is open to verification. The cost of capital may then decline
slowly when the initial disclosures are shown to be valid and the markets start
to trust the board. If the company develops a reputation for keeping the
markets informed in a timely and accurate manner then the directors will
develop a reputation for honesty and the cost of capital may remain at a lower
level.

This question was possibly the least well done question of the paper. Parts (i) and (iii) were
badly done with candidates making a variety of mistakes. The theory part of the question was

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 Subject CT2 (Finance and Financial Reporting) – April 2013 – Examiners’ Report

done badly by a number of candidates, with some of the explanations given showing very
little understanding of the subject.

END OF EXAMINERS’ REPORT

Page 10
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2012 examinations

Subject CT2 – Finance and Financial Reporting

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

D C Bowie
Chairman of the Board of Examiners

December 2012

© Institute and Faculty of Actuaries

 Subject CT2 (Finance and Financial Reporting) – September 2012 – Examiners’ Report

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 essay
type questions on these topics. The paper also examines financial reporting including
preparation of the main financial statements and interpretation of financial statements it also
considers the basis of the preparation of statements and the information needs of a variety of
end users of financial statements.

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

Comments on the September 2012 paper

The general performance was slightly poorer than in April 2012 although well-prepared
candidates scored well across the whole paper. The comments that follow the questions
concentrate on areas where candidates could have improved their performance. The main
problems were Q14 and 20.

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 Subject CT2 (Finance and Financial Reporting) – September 2012 – Examiners’ Report

1 C
2 C
3 B
4 B
5 C
6 B
7 C
8 C
9 A
10 C

Workings

1 A 1.40 × 10/11

B (1.40 × 10/11) + 7%

C present share price – unchanged because the return on each share is expected
to remain constant

D 1.40 + 10%

6 Equity = Assets – liabilities

A £25,000 = (100,000 + 7,000) – (82,000) − Ignore WC

B £32,500 = (100,000 + 7,000 + 8,000) – (82,000 + 500) – correct answer

C £40,000 = initial stake

D £52,500 = (100,000 + 7,000 + 8,000) – (82,000 + 500 – 20,000) – ignore initial

loan

8 A 40/(150 + 60) × 365 = 70 days – total sales

B (40 + 5)/(150 + 60) x 365 = 78 days – total sales and sundry debtors
C 40/150 × 365 = 97 days – correct answer
D (40 + 5)/150 × 365 = 110 days – includes sundry debtors

The MCQs were done well as usual.

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 Subject CT2 (Finance and Financial Reporting) – September 2012 – Examiners’ Report

11 The company will offer greater flexibility in the future. Admitting fresh capital will
require only the sale of shares to one or more new principals. The company will
probably be easier to sell in the future because there will be greater clarity over its
assets and liabilities. There will be fewer matters that have to be agreed or decided at
the early stages of the business’ existence because the company will have to be
incorporated and managed in accordance with the requirements of company law. The
company will have to prepare its accounts in accordance with specific accounting
standards and that will give the company a more credible track record when dealing
with third parties. The partners’ personal liability will be restricted to the guaranteed
loan, so the other creditors will not be able to seek compensation from their personal
assets.

This question was done well by most candidates.

12 The directors will be aware that any inefficiency could lead to the shares becoming
devalued. In that case it will have the effect of encouraging a third party to make an
offer to buy a controlling interest. Such bids usually involve the payment of a
premium over the market price and so they will only make commercial sense if the
direction of the company is changed and refocused in the aftermath of the takeover.
That usually means replacing the management team and so the existing directors will
be made redundant. If the takeover is contested then there is likely to be a public
argument about the company’s ineffective management and so the directors’
reputation will be damaged and they will be less marketable in terms of their careers.
On the other hand, the directors have a responsibility to act in the interests of the
company’s current shareholders, and if the existing shareholders were going to take
cash then any overvaluation is in their interest and they should not be concerned about
the future direction of the company.

This question was done badly by some candidates with very few candidates mentioned
replacing the management team or ensuring the management team was effective.

13 The most obvious advantage is that management costs will be substantially reduced
compared to a more proactive fund. The fund’s managers do not need to conduct
extensive research because they are actively trying to “buy the market” and so there is
no need to spend time and incur cost in identifying “good” investments. That will also
mean that there are likely to be fewer agency issues because the fund’s managers do not
need to deliver performance that exceeds the market rate. If the index has a weak return
then the fund will mirror that, but the managers will still have performed in accordance
with expectations. Dealing costs will also be reduced because the only transactions that
will be necessary will be the very occasional purchase or sale to refocus the balance of
the fund if it starts to fall out of line with the index that it is tracking. Such funds will
also be attractive to investors who wish to diversify in a particular direction that is
served by a fund, into such investments as Singaporean securities or whatever.

Investing in this fund will offer investors a degree of diversification, which may be
less risky for those investors who would otherwise buy a narrow range of securities.

This question was done very well by many candidates.

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 Subject CT2 (Finance and Financial Reporting) – September 2012 – Examiners’ Report

14 The uncertainty will create a distraction for management because they will have to
agree an interpretation with the tax authorities. That will increase legal and
accountancy fees because the directors have a duty to resolve any disagreement in the
company’s favour. This could prove expensive because the tax authorities have the
backing of government and are likely to afford to spend more in the pursuit of an
increased tax payment than the company can spend in defence. The tax authorities
could be motivated by the desire to establish a precedent and that could mean the case
gets blown out of all proportion.

The uncertainty will make it far more difficult for the company to budget and plan its
cash flows. There is also a risk that the company will base major decisions on
assumptions about tax planning that could prove to be invalid if the tax authorities
press for a different interpretation.

This question was done very badly which was disappointing.

Many candidates did not answer what was asked in the question but discussed tax in
general.

15 It is possible that management will have a change of heart in the course of an

extensive loan period. For example, a fixed rate loan could have been taken out at a
time when it was felt that interest rates were likely to rise, but that threat could have
passed. Switching to a variable rate loan could prove cheaper. Swaps provide a far
cheaper alternative to facing the penalties associated with early repayment and the
replacement of one loan with another.

Some entities have a specific advantage in a particular area of finance. For example,
banks often raise funds at variable rates by taking customer deposits. It is attractive to
diversify by mixing fixed rate with variable rate liabilities. Banks can offer a variable
rate loan via a swap arrangement at a rate that would be more attractive to many
borrowers than a straightforward variable rate loan arranged in the traditional way.

This question was done very well by many candidates.

16 Issuing fresh shares can undermine the interests of existing shareholders. For
example, the shares will normally have to be issued at a discount and that will dilute
the existing shareholders’ investments. Also, the directors could place shares in such a
way as to interfere with the ability of particular groups to exercise control.

Rights issues mean that there can be no dilution effect because the shareholders can
either buy the shares and take advantage of the discounted price or they can
compensate themselves by selling the rights. There is also no question of passing
control to a particular group by placing shares with them or of excluding a powerful
group of shareholders from a placement. Existing shareholders can continue to hold
their present proportion of the company provided they can afford to take up their
rights.

The stock exchange rules or the company’s articles may require the use of rights
issues.

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 Subject CT2 (Finance and Financial Reporting) – September 2012 – Examiners’ Report

This question was answered very well by most candidates.

17 Simulation copes with the mathematical problems associated with more traditional
modelling of investment decisions. Provided the probability distributions are
reasonably realistic then there is no need to solve all of the equations that are implied
by a more traditional model. Computing power is cheap and readily available and so
the simulation can be run as frequently as necessary to be confident that the results are
robust. The output is relatively easy to understand because the results can be
expressed in terms of the probabilities of achieving a result that is better or worse than
a given target.

The advantages must be discussed in terms of the potential drawbacks. The fact that
there is no mathematical solution means that the results could be very misleading if the
model is incorrectly specified. Such errors may not come to light until it is too late.
The technique is reliant on the quality of inputs and assumptions and by increasing the
number of assumptions about probability distributions or project outcomes, you
increase the risk that some of them are invalid.

This question was answered reasonably well; some candidates did not discuss that the
results could perhaps be misleading.

18 One problem is that businesses are complex entities and their accounting issues are
often difficult to understand. The interests of shareholders and other users are also
complex and it is difficult to know exactly what information is required, especially
given the possibility that shareholders have access to information from sources other
than the annual report.

The fact that the standard setting process is international means that standard setters
have to cope with cultural problems in terms of different business practices. Even the
translation of standards into other languages will affect the standard setter’s task.

Historically, standards have been set in response to problems with accounting and that
has made the standard-setting process reactive. Preparers of financial statements can
also interfere with the standard setter’s ability to enforce unpopular standards.

This question was answered reasonably well by many candidates. Many candidates gave good
answers that included good discussion of international standards and the problems associated
with translation.

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 Subject CT2 (Finance and Financial Reporting) – September 2012 – Examiners’ Report

19 (i) Foxton is considerably smaller than Echo in terms of revenue and would not
impact Dayton’s revenue to the same extent. Echo has the higher return on
capital employed of the two alternatives, but both are lower than Dayton.
Dayton will take a reduction on ROCE in either case, but it is not necessarily
clear which of the two will have the greater impact when size is taken into
account. The following could be used to estimate the impact:

Dayton Echo Foxton

Profit = profit margin × revenue £130m £55m £46m
Capital employed = profit/ROCE £722m £393m £418m
Revenue £500m £250m £140m
Dayton’s revised ROCE when combined 17% 15%

Foxton has a higher profit margin and so it will enhance Dayton’s margin
when the two businesses are combined. Dayton will appear to be a better
trader when combining the figures

Both Echo and Foxton have lower gearing ratios than Dayton. Unfortunately,
both will be forced to cancel preacquisition equity if they are consolidated and
so both will simply add liabilities to Dayton’s statement of financial position.
Thus, in the short term, Dayton’s gearing will increase even further. In the
longer term, Foxton can generate £140m × 33% = £46.2m of profit every year
and Echo £250m × 22% = £55m and so both will start to accrue retained
earnings for the group, thereby diminishing gearing.

The P/E ratios suggest that Echo will be the more expensive acquisition
because the markets presently value the company at a higher multiple of
earnings and the company is also larger to begin with. It may be that Foxton
will be the better investment because the same industrial and commercial logic
applies to each company and so Dayton can build its entry into that niche just
as easily from Foxton as from Echo.

(ii) The financial statements are not designed for this purpose. The accounts are
prepared to assist the shareholders with stewardship decisions concerning the
actions of the directors and are not intended to stand alone as the basis for an
investment decision. For example, the information in the financial statements
is historical whereas valuation is always forward-looking. Also published
accounts value assets on the basis of going concern and ignore some
adjustments that a buyer would insist upon. For example, the valuation of
inventories and receivables may be relatively rough and may overlook
overstated figures that would concern a buyer.

There is also the possibility that the preparers of financial statements have
taken advantage of the flexibility in accounting to push the reporting earnings
in a desired direction. The directors may wish the shares to change hands at the
highest possible price and profit could be influenced so as to bring that about.

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 Subject CT2 (Finance and Financial Reporting) – September 2012 – Examiners’ Report

(iii) Goodwill is the difference between identifiable net assets and the price paid.
That suggests that Echo’s likely selling price will be affected to a greater
extent by unrecognised intangibles such as brand names and human assets.
That goodwill will drive down the ROCE in the consolidated financial
statements. It will also leave the group exposed to a greater threat of
impairment adjustments because there is more goodwill to be impaired.

Generally all parts of this question were answered reasonably well. Part (iii) was the poorest
with candidates not demonstrating much knowledge of intangible assets. Candidates were
unsure of the effect on ROCE.

20 (i) Banks impose restrictive covenants on further borrowing because they do not
wish to risk their principal being left unpaid if the company is forced into
liquidation. If a company fails then lenders are paid out of its assets before the
shareholders receive anything. Limiting the proportion of assets financed by
borrowing should ensure that here are sufficient assets to pay all creditors in
full. If there are not then many lenders will be forced to settle for just a
percentage of the amount that is owed to them.

Lenders will also wish to restrict total borrowings because high gearing
increases the risk that a company will fail because of the need to raise cash in
order to service debt. Even if the company has sufficient funds to pay lenders,
there will be costs (e.g. legal expenses) if the loan defaults. It will also leave
lenders with cash that they have no immediate use for and so it will cost them
interest if they are repaid early and without much advance
warning.

Limiting gearing might also make the shareholders more risk averse. If the
company has been financed largely from borrowings then the shareholders
might feel rather reckless because much more of the risk is being borne by
lenders. Making the shareholders commit a significant amount of their own
money to the venture means that the business should be managed more
responsibly.

(ii) Allowing borrowings to come close to the maximum means that the
company’s finances will be less flexible and less responsive in the face of new
opportunities. It can be difficult to raise equity quickly and it is often
uneconomical to raise equity in relatively small amounts. Loans can be raised
relatively quickly and for comparatively short periods. This makes it desirable
for a company to have some borrowing capacity free.

If the gearing ratio is close to the maximum then any losses might reduce
equity and that could create problems with meeting loan conditions. Similarly,
downward revaluations of fixed assets could reduce equity and increase
gearing to unacceptable levels.

Banks might be reluctant to continue short-term overdraft facilities if the

company is viewed as highly geared. They might decide to reduce the

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 Subject CT2 (Finance and Financial Reporting) – September 2012 – Examiners’ Report

overdraft limit at a time when the gearing ratio would make it difficult to raise
fresh debt from other sources.

There is always a risk that new accounting standards will be introduced that
will have the effect of reducing the book value of equity or increasing the
book value of debt. The closer the company is to its borrowing limits, the
greater the risk that any new standard will cause problems.

(iii) (a) The capital markets will not be aware of the decision to turn down a
positive NPV project and so the assertion may be true in the short term.
The problem that arises is when the company passes on so many
opportunities that reported earnings start to decline. Ongoing
investments are generally necessary in order to maintain a competitive
edge and keep the company on track to meet investor expectations.
Investors will also start to benchmark the company against similar
businesses and will see the effects of the competitors’ investments in
terms of revenues and profits. This is clearly going to be a significant
issue in an industry such as entertainment where companies are
constantly announcing new products and fresh directions.

(b) This ignores the fact that the shareholders can diversify for themselves.
The CAPM suggests that shareholders evaluate risk on the basis of
diversified portfolios and the specific risks associated with, say,
specific industry characteristics, disappear because of diversification.
The shareholders are more likely to be confused by an investment that
takes Hatton away from the core business that the board clearly
understands. Diversification by the company will create inefficiencies
that are likely to reduce the share price. On the other hand,
diversification within the company may help avoid the costs of
possible financial distress and so be of value to the shareholders.

This question was done badly. Part (iii) was poor especially part (b). Part (i) was not too bad
and part (ii) was poorer. Generally candidates understood that high gearing was risky and
why but in part (ii) they did not do well.
In part (iii)(b) candidates generally could not answer this question and did not discuss
diversification.

END OF EXAMINERS’ REPORT

Page 9
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2012 examinations

Subject CT2 – Finance and Financial Reporting

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and who are using
past papers as a revision aid, and also those who have previously failed the subject. The
Examiners are charged by Council with examining the published syllabus. Although
Examiners have access to the Core Reading, which is designed to interpret the syllabus, the
Examiners 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 in
this report. Other valid approaches are always given appropriate credit; where there is a
commonly 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 contains
all the points for which the Examiners awarded marks. This is much more than a model
solution – it would be impossible to write down all the points in the report in the time allowed
for the question.

T J Birse
Chairman of the Board of Examiners

July 2012

© Institute and Faculty of Actuaries

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

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 essay
type questions on these topics. The paper also examines financial reporting including
preparation of the main financial statements and interpretation of financial statements it also
considers the basis of the preparation of statements and the information needs of a variety of
end users of financial statements.

Different numerical answers may be obtained to those shown in these solutions depending on
whether figures obtained from tables or from calculators are used in the calculations but
candidates are not penalised for this. However, candidates may be penalised where excessive
rounding 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, overseas
candidates did not perform quite so well as UK candidates. The comments that follow the
questions concentrate on areas where candidates could have improved their performance.
Candidates approaching the subject for the first time are advised to concentrate their revision
in these areas. The main questions that caused candidates difficulty were Q19 and 20.

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

1 C
2 D
3 B
4 C
5 D
6 A
7 B
8 C
9 D
10 B

The MCQs were done well.

11 Most individual shareholders pay income tax at their highest marginal rate when they
receive any dividend income. They have very little opportunity to manage that
liability and so tax will almost certainly become payable whenever a dividend is
received.

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

In addition, individual shareholders receive an annual allowance that can reduce the
amount paid on gains beneath the allowance to zero. Furthermore, the tax rate on
capital 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 tax
system.

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 the
debt phase of the instrument. While that interest may be payable at a lower rate than
would be paid on an outright loan, it is still a commitment that the new business will
have to make.

In the event that Martha’s business succeeds, the chances are that the bondholder will
convert the bond to shares. That will dilute her equity and will reduce her return from
having 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 the
business is at its most vulnerable and will reduce the upside risks associated with any
success that the business enjoys.

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

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

13 Currency futures can be used to manage risk exposures. The most logical use for a
future 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 had
been forced to invoice in the customer’s currency there could be a risk that the rates
will move adversely during the period before settlement. A currency future could be
entered into so that the sum due is sold for delivery at a future date, thereby
guaranteeing the company’s future receipt. The only significant cost would be the
interest foregone on the margin deposit that would have to be made.

Futures can also be used to create a substantial exposure for speculative purposes. An
investor who predicted a significant shift in a particular currency that appears to have
been mispriced could enter into a futures contract in order to obtain a more significant
position 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 and
had very little detail.

Candidates had very little knowledge of this area. Many knew what futures were, but did not
know much more and were unsure what they were for.

14 The directors are ultimately responsible for the company’s administration and any
relationships that it develops with third parties. They cannot make somebody else
responsible for those matters even if their expertise in engineering means that they are
not particularly well equipped in business or financial management. They can, of
course, delegate the actual work of maintaining books or talking to banks to a
financial manager if they so wish.

The company’s accountant will be required to fulfil the duties that are spelled out in
the contract of employment. Those duties may have to be discharged in accordance
with standards imposed by the accountant’s professional body. The directors will bear
the ultimate legal responsibility for ensuring that the company is compliant with all
relevant legislation, but the directors will be entitled to expect that the work will be
completed 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 period
that amounts to virtually the whole of the asset’s anticipated useful life. Provided the
lessee makes the agreed lease payments the lessor will have little or no rights over the
asset. Thus, the lessee can make full use of the asset for most or all of its useful life
and thereby enjoys the full rewards of ownership.

Such lease arrangements are unlikely to be cancellable because the lessor will
normally acquire the asset to meet the lessee’s specifications. The lease payments will

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

continue even if the asset becomes obsolete or redundant because the lessee’s needs
change. The lessee will almost certainly have to agree to accept responsibility for any
loss or damage to the asset while it is in the lessee’s custody. Thus, the lessee will
effectively 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 cheaper
than equity. The shareholders enjoy the benefit of the wealth created from the lenders’
investment and they also enjoy the benefits of the tax shield on borrowing. The risks
associated with borrowing are borne directly by the company and so the shareholders
will 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 fails
because it cannot meet its loan commitments then the directors will face the loss of
their jobs. If they issue further shares then the shareholders will be unlikely to ever
have an incentive to put the company into receivership because they will lose
everything 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 it

informs 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 to
whether an asset should be retained or sold requires an understanding of the future
cash flows that it will generate and also of the amount that it will realise on the open
market.

Information is reliable if it can be checked easily and measured against an objective

benchmark. Generally, reliable information is historical and may not necessarily have
much predictive value. For example, the historical cost of an asset is a very reliable
measure 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 to
informing the shareholders. The figures in the financial statements may be designed to
report past profitability, whereas the lenders would prefer a conservative evaluation of
the present position to inform decisions about collectability. The information in the
financial statements is largely historical, whereas lenders are primarily interested in
future cash flows to ensure that they are capable of servicing a loan commitment. The
statement of financial position will list the company’s 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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 Subject CT2 (Finance and Financial Reporting) – April 2012 – Examiners’ Report

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

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

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

19 (i) Depreciation is effectively the recognition of the fact that an entity consumes
resources in the form of property, plant and equipment when manufacturing
goods. Barton’s depreciation charge is based on a percentage of the historical
cost of the assets being used. Barton’s assets are very old and so those
historical costs have become virtually meaningless. The resulting depreciation
figure is perfectly consistent with accounting regulations, but it is not
necessarily representative of the costs being incurred when reporting to
decision makers. Any comparable business would have to report a much
higher depreciation charge because it could not acquire assets for the same
price as Barton. The property is stated at historical cost and therefore the
depreciation charge is likely to be lower than if it was charged on current
values.

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

(ii) Notional cost of assets = £1.2m

Notional useful life = 10 years
Charge = £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 is
more relevant than their historical cost. The resulting depreciation recognises
the economic cost of the wear and tear.

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

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

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

(iv) The negotiation of the selling price of a business is complicated by the fact
that accounting regulations do not necessarily lend themselves to every
situation. Barton’s machinery has been fully depreciated on a historical cost
valuation and the fair value of the assets is normally determined by looking at
their market valuation, which is also zero. Thus, Barton’s owner can claim that
depreciation on production machinery is zero and such a claim is consistent
with accounting regulations. If the owner insists on making the best possible
use of this loophole then profit may be overstated and that could be used as an
argument to inflate the selling price for the business.

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

(v) The proposal involves basing the selling price on a multiple of profit. That
automatically incorporates the effects of the factors that the owner has
mentioned. The company’s good name and customer base will have
contributed to past profits and so they are included in the valuation of the
company as a going concern. The fact that they are not being priced separately
does not mean that they are being excluded altogether.

It could be argued that the good name will become less valuable if Barton is
taken over and becomes associated with a large and modern company. Part of
the reason for company’s success in this niche is the fact that it is a small
company 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 requires
all 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 any
particular project, but the alternative would be to invest significant time and
effort in determining a more realistic target for each investment and there is no
guarantee that the resulting figures will be any more suitable. All investment
decisions require subjective decisions about the risks and returns.

The fact that Manor is investing in property means that it is fairly unlikely that
it will be faced with a massive risk of loss on a project, even if it is necessary
to hold an investment until a market blip sorts itself out. Also, the fact that the
projects have a typical life of three to five years means that using a different
discount rate would have very little impact on the overall net present value.
More stringent criteria would be justified in the case of a different industry
with 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 scenario
set out in the question at all but just discussed NPV in general terms.

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

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

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

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

Clearly, the shareholders will not necessarily be aware of investments unless

the 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 strategy

then the shareholders will only become aware of that when the results of those
investments start to appear in the published accounts. It may take at least two
or three years before a series of weak returns starts to impact on reported
ROCE.

This part was done badly by almost all candidates. Candidates did not mention shareholders
and 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” is
unlikely to achieve the anticipated results and is likely to be a disappointment.
The shareholders will almost certainly wish the directors to evaluate any
projects on the basis of the outcomes that are likely to be achieved and they
may regard the use of will lead to the acceptance of best possible as a
dishonest attempt to justify unsuitable investments.

It could be worth considering the best possible outcome as one aspect of

decision-making. Risky projects often have an upside potential as well as a
downside and so the possibility that an upside may be enjoyed is worth
considering 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

Page 8
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2011 examinations

Subject CT2 — Finance and Financial Reporting

Core Technical

Purpose of Examiners’ Reports

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and who are using
past papers as a revision aid, and also those who have previously failed the subject. The
Examiners are charged by Council with examining the published syllabus. Although
Examiners have access to the Core Reading, which is designed to interpret the syllabus, the
Examiners 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 in
this report. Other valid approaches are always given appropriate credit; where there is a
commonly 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 contains
all the points for which the Examiners awarded marks. This is much more than a model
solution – it would be impossible to write down all the points in the report in the time allowed
for the question.

T J Birse
Chairman of the Board of Examiners

December 2011

© Institute and Faculty of Actuaries

 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, September 2011

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 essay
type questions on these topics. The paper also examines financial reporting including
preparation of the main financial statements and interpretation of financial statements it also
considers the basis of the preparation of statements and the information needs of a variety of
end users of financial statements.

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

Comments on the September 2011 paper

The general performance was slightly better than in April 2011 well-prepared candidates
scored well across the whole paper. As in previous diets, overseas candidates did not perform
quite so well as UK candidates. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Candidates approaching the
subject for the first time are advised to concentrate their revision in these areas.

Page 2
 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, September 2011

1 D
2 C
3 C
4 B
5 D
6 D
7 A
8 C
9 C
10 D

Workings for question 2:

A – one on every five shares cancelled
B – 4m shares issued at £5 + 3 = £8 each
C – theoretical ex rights price for 6 shares = (£5 × 5) + £3 = £28 = £4.67/share 9
D – market capitalisation = £100m, less 4m shares issued at £3 = £88m

Workings for question 8:

A – 700 – (500 + 20)
B – 700 – 500
C – 700 – (500 – 20) 9
D - 700

The multiple choice questions were done very well by most candidates. No question caused
any more problem than another.

11 Trade credit is advanced by suppliers, who permit payment to take place sometime
after the delivery of the goods . This is a relatively simple arrangement that is easy to
obtain if the customer has a reasonable credit history . There is no interest as such,
although the purchase price will include something for the cost of credit. If excessive
time is taken to pay for goods then the credit facility may be withdrawn .
Debt factoring is effectively a means of borrowing against the company’s trade
receivables. The factor may assume the risk of bad debt. There is an explicit interest
charge for this finance.

This question was answered well by most candidates.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, September 2011

12 There will be the usual issuing costs if the quotation takes the form of an offer for
sale. There will also be costs in terms of accountability, with the need to meet the
stock exchange’s disclosure requirements.

Being quoted will make it easier to issue new shares because the shares will be more
readily marketable. The existing shareholders will benefit from the ability to liquidate
their investment. The quotation will also enable the shareholders to value their stakes
very easily because there will be a recognisable market price.

This question was answered very well by most candidates.

13 Interest on debt can be claimed as an expense for tax purposes. That will make the
cost of debt much cheaper than equity. The tax saving will only materialise if the
company is making taxable profits. Profit should be forecast into the foreseeable
future to establish whether the anticipated profits will be large enough to enable the
tax savings to be utilised. If there will be insufficient profit then the cost of interest
should be evaluated gross. There will always be a risk associated with borrowing and
so the decision should not be based on cost alone, regardless of the tax savings.

This question was done poorly by some candidates. The main point which was not discussed
was the tax effect on the cost of debt.

14 The IASB develops IFRSs . These standards form the starting point when reviewing
the accounting policies applied by a company. If a company does not comply with
IFRS then the auditor is likely to qualify the audit report. Shareholders and other
stakeholders will also expect the statements to be prepared in accordance with IFRS.

IFRS have been instrumental in reducing differences between companies and in

making financial statements more comparable. That has been a significant
improvement in terms of establishing the credibility of the regulation of accounting.

This question was answered well by many candidates. Most candidates knew that the
financial statements had to be prepared using rules in the standards. Few candidates
mentioned the auditor

15 An associate is subject to significant influence from the holding company. Influence

is normally obtained when the holding company has a significant stake, but not
sufficient to grant control. Owning 20% or more, but less that 50%, will normally
create this relationship.

The fact that the holding company can merely exert influence means that it would not
be appropriate to include the value of its assets in the consolidated financial
statements. Instead, the holding company’s share of the associate’s results are
included in the consolidated income statement — regardless of whether it actually
receives these by way of dividend. The consolidated statement of financial position

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 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, September 2011

includes the holding company’s share of the associate’s assets and liabilities, but as a
single line item in the accounts.

This question was not done particularly well. Some candidates made a very poor attempt at
this. It just had to be learned from the manual so it was surprisingly badly done.

16 The need for diluted EPS arises because the basic EPS calculation ignores the impact
of “potential” shares. Companies can issue warrants, options, convertible securities
and so on, all of which give their holders the right to obtain shares on preferential
terms. If those rights are exercised, the EPS enjoyed by the existing shareholders will
be diluted because the equity introduced will not be sufficient to compensate for the
larger number of shares ranking for a dividend.

The EPS ratio is an important ratio used to measure and discuss the company’s
profitability. It is the basis for the Price/Earnings ratio which is used to determine the
company’s strength. Any distortion of the EPS ratio will confuse the discussion of
P/E.

There were some excellent answers to this question which was very heartening.

17 The least expensive form of finance is likely to be the one that offers the lowest risk
to the provider. Risk cannot be eliminated, but it can be passed from one party to
another and the less risk taken by the provider the greater the risk being taken by the
borrower. For example, bank loans are likely to give the lender significant rights in
the event of default. That protects the lender, but means that the borrower faces
closure in the event that a vital asset has to be surrendered in the event that the lender
exercises those rights.

The fact that equity passes the risk to the investor explains why it is more expensive
than debt. The company need not pay shareholders a dividend unless it can afford to.

This question was not done very well at all. Few candidates could say why debt was cheaper
than equity and most did not relate this to risk. Risk is an important consideration when
considering the financing decision and this plays a major part in the cost of debt and equity.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, September 2011

18 The members of the group have to be identified. The holding company has to ensure
that all entities that are controlled are included in the group accounts as subsidiaries.

Consolidation involves cancelling all internal balances between group members. Any
such balances will have to be identified so that they can be eliminated against one
another. One effect of that is that goodwill on consolidation will have to be
recognised and accounted for in order to ensure that the statement of financial
position still balances after eliminating investments against the corresponding equity .

The balance invested by the non-controlling interest will have to be determined and
accounted for too.

This question was done well by most candidates.

19 (i)

Most likely demand

Without furnace
Year 0 cash flows = (2,000,000) NPV = (2,000,000)
Year 1 cash flows = Sales 10,000,000 NPV = 5,200,000 × 0.917 = 4,768,400
Material (4,000,000)
Labour (800,000)
Total 5,200,000

Years 2–5 cash flows = Sales 30,000,000 NPV = 17,200,000 × (3.889 − 0.917) = 51,118,400
Material (12,000,000)
Labour (800,000)
Total 17,200,000
Total 53,886,800

With furnace – incremental cash flows

Year 0 cash flows = (1,200,000) NPV = (1,200,000)
Year 1 cash flows = Material 2,500,000 NPV = 2,500,000 × 0.917 = 2,292,500
Years 2–5 cash flows = Material 7,500,000 NPV = 7,500,000 × (3.889 − 0.917) = 22,290,000
Year 5 cash flow = (1,500,000) NPV = (1,500,000) × 0.650 = (975,000)
Incremental saving 22,407,500
Total 76,294,300

Least likely demand

Without furnace
Year 0 cash flows = (2,000,000) NPV = (2,000,000)
Year 1 cash flows = Sales 4,000,000 NPV = 1,600,000 × 0.917 = 1,467,200
Material (1,600,000)
Labour (800,000)
Total 1,600,000
Years 2–5 cash flows = Labour (800,000) NPV = (800,000) × (3.889 − 0.917) = (2,377,600)
Total (2,910,400)

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 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, September 2011

With furnace – incremental cash flows

Year 0 cash flows = (1,200,000) NPV = (1,200,000)
Year 1 cash flows = Material 1,000,000 NPV = (500,000) × 0.917 = (458,500)
Decommissioning (1,500,000)
Total (500,000)
Incremental outflow (1,658,500)
Total (4,568,900)

This part was not done well by candidates. Many made careless mistakes and lost some
marks.

(ii) The expected value if the furnace is not purchased is

(53,886,800 × 70%) + (− 2,910,400 × 30%) = £36,847,640.

The expected value if it is purchased is

(76,294,300 × 70%) + (-4,568,900 × 30%) = £52,035,340

Candidates did well in this part and their own figure was used in this part so
they were not penalised twice for a mistake in part i.

(iii) The expected value information provides very little useful information in this
case because it does not reflect the returns that will actually be enjoyed.

In each case, there is a 70% chance of a positive NPV and a 30% chance of a
smaller, but still significant, negative NPV. In that context, the value of the
potential cash flows may bear little or no real relationship to their weighted
average. Risk averse individuals may decide that a 30% chance of losing
£2.9m or £4.6m is a good reason to abandon the project, even though there is a
corresponding chance of a much higher gain.

Very few candidates could explain expected value or understood what the figures meant. This
was disappointing.

(iv) The directors cannot really consult the shareholders over decisions such as this
ad so it is difficult to develop a clear understanding of the shareholders’
preferences. There will always be some risk associated with an investment and
so the directors will find it difficult to avoid risks if they are to generate any
meaningful return. Abandoning projects because they have a downside will
always lead to a lost opportunity.

The directors face the problem that the company will release only limited
information about the project and so the shareholders may not fully appreciate
the benefits that it will generate for them. The board could be criticised
unfairly for proceeding with a sound decision.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, September 2011

The outcome of the project will be evaluated with the benefit of hindsight. The
shareholders may find it difficult to see beyond the fact that the most likely
demand did not materialise if the project fails and they lose money as a result.
The directors may be deterred from investing in projects that have a significant
downside because of that.

This part was done poorly by candidates. The candidates generally do not do so well when
asked to demonstrate understanding of the results.

20 (i)
North South
Profitability
Return on capital 592/(1,400 + 450) = 32% 1,247/(2,515 + 200) =
employed 46%
Gross profit percent 960/1,600 = 60% 1,885/2,900 = 65%
Advertising/revenue 240/1,600 = 15% 522/2,900 = 18%
Liquidity
Current ratio 160/310 = 0.5:1 455/40 = 11.3:1
Efficiency
Receivables turnover 160/1,600 × 365= 37 455/2,900 × 365 = 57
days days

Both companies have strong return on capital employed, but South is much
stronger than North. The margins are higher and so North may be
concentrating on more lucrative work. It may be that South is getting a better
return on its advertising because it is spending more and that might be
necessary in order to get a return. South also appears to be more efficient
because it is generating a much higher turnover from only a slightly higher
asset base.

North has a large overdraft relative to current assets, which is a major worry.
If the overdraft is called in then North could be rendered insolvent. South has
no such problems

North has a much shorter receivables turnover. That may explain its lack of
success in generating new business. If the company presses for prompt
payment then customers may be tempted to go elsewhere. It may be that the
cash is being chased because of the burden of servicing the large overdraft.

This part was done reasonably well by candidates. Many did the calculations well but did not
explain their results very clearly.

(ii) The directors should consider whether the figures are directly comparable. The
accounting policies should be the same in both companies, but the underlying
assumptions may be different. For example, South may be a little more
aggressive when it comes to booking turnover.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, September 2011

The nature of the local markets may also be different. It may be that North is
already doing as well as is possible, subject to the local conditions. Changes
may actually be harmful.

South is much bigger in terms of turnover and that might create economies of
scope that are not available to North. For example, South may be able to
employ a wider range of consultants.

This part was reasonable.

END OF EXAMINERS’ REPORT

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 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2011 examinations

Subject CT2 — Finance and Financial Reporting

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

T J Birse
Chairman of the Board of Examiners

July 2011

© Institute and Faculty of Actuaries

 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, April 2011

General comments

This exam had some excellent results. There was a high pass rate and some candidates
scored highly.

The parts of the exam which were done poorly tended to be the finance sections rather than
the accounting questions. Most candidates who intend resitting are likely to benefit from
concentrating their revision on the finance topics.

The answers to the questions were mixed, some were excellent but others, particularly
questions 13, 15, 17, and 19 were poor.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, April 2011

1 A
2 B
3 C
4 B
5 C
6 C
7 B
8 D
9 D
10 B

Working for q3:

Market capitalisation = £20m before rights issue + (2m × 1.60) = £23.2m for 12m shares =
£1.93/share 9
Average price = £1.80

Workings for q8:

Correct answer = 5,000 – ((5,000 − 200)/10 × 3) = 3,560 9
Ignore residual = 5,000 – ((5,000)/10 × 3) = 3,500
Add residual = 5,000 – ((5,000 + 200)/10 × 3) = 3,440
Subtract residual from cost = (5,000 – 200) − ((5,000 − 200)/10 × 3) = 3,360

Working for q10:

Correct answer = (700,000 + 48,000)/(400,000 + 470,000 + 600,000) = 51%
Wrong return = 700,000/(400,000 + 470,000 + 600,000) = 48%
Exclude retained earnings = (700,000 + 48,000)/(400,000 + 600,000) = 75%
Exclude liabilities = (700,000 + 48,000)/(400,000 + 470,000) = 86%

The MCQs were done very well by most candidates. No one question appeared to cause a
significant problem for candidates.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, April 2011

11 The shareholders enjoy any profits after interest and tax and are keen to see the
company prosper. The lenders wish to have their agreed interest and repayments.
Neither party will necessarily benefit if the other suffers. If the company is unable to
repay its lenders then the shareholders may lose everything. If the company does not
make a profit then it may prove difficult to meet loan repayments.

There is a difference in risks, which could have an impact on the differences between
the shareholders and the lenders. The shareholders enjoy upside risks, whereas there
are no real upside risks for lenders. Thus, lenders may have no incentive to encourage
significant risk-taking on the part of the companies that they lend to. There may be
times when shareholders have very little downside risk. For example, if the company
is in difficulties then the shareholders may feel that there is little to be lost if the
company takes risks in order to deal with the problem. If the company is going to fail
anyway then the risks will cost them nothing if the risky strategies fail but the lenders
may suffer if the funds that would be used to meet their repayments are lost.

This question was done very well by many candidates.

12 Admitting a partner is a serious matter. The new partner will be entitled to an agreed
share of any profits, which could prove expensive to Simon. Simon will also be
jointly and severally liable with the new partner, even if the liabilities arise from an
act or omission on her part.

Presumably the new partner will be expected to buy her way into the equity and that
could generate long term funding for the business.

Granting a partnership should avoid the risk of this person leaving Simon’s practice.
That may be a good enough reason for the partnership in itself if Simon has become
dependent on this individual. She will also be more highly motivated by the fact that
she has a personal stake in this business.

This question was also done well with a number of candidates scoring full marks.

13 Preference shares are only equity in the legal sense of the relationship between the
company and the shareholder. Preference shares carry a fixed dividend, which has
exactly the same impact on the ordinary shareholders’ returns as borrowing. If the
preference dividend is suspended then the rights are likely to be carried forward, so
the dividend will be paid eventually. Shareholders are also likely to have additional
rights in the event that the preference dividend is in arrears.

Historically, preference shares have often been designed to avoid showing debt in the
statement of financial position. It has become important to show them as debt because
that has been the motive for issuing them.

This question was not done very well by candidates which was disappointing. Most
candidates got the points about the fixed dividend but few mentioned that a fixed
return was similar to debt.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, April 2011

14 Depreciation requires highly subjective judgements that can be exploited to manage

the resulting depreciation figure. If depreciation could be charged as an expense then
the company could virtually determine its own tax charge.

Capital allowances are calculated in a consistent manner, so the tax authorities know
exactly what they will be. That avoids the risk that time will have to be spent
checking and evaluating the calculation.

The tax system can also permit the encouragement of investment. For example, the
initial rate can be as high as 100% in the first year, so that there is an additional cash
flow advantage from the tax system.

This question was done very well by many candidates. No significant problems were
noted at all.

15 The IRR criterion will give the same result as the NPV method in simple cases where
the only matter to be decided is whether to invest in a simple investment. The
disadvantage is that the computation is generally more complicated and requires trial
and error or a spreadsheet for an accurate measure.

IRR can be misleading when the decision is more complicated, such as deciding
between two investments. IRR makes no adjustment for the scale of the investment
and so it could lead to the wrong project being selected NPV always expresses the
result as an absolute value for the change in shareholders’ wealth. That means that the
impact of the investment is always visible.

This question was done poorly. This should have been a straightforward question as
it was knowledge based, however the level of knowledge shown was quite poor.

It is generally the finance questions that candidates do not answer adequately.

16 The money measurement concept requires that accounting statements restrict

themselves to matters which can be measured objectively in money terms. That
simplifies accounting enormously because it excludes such items as the values of the
company’s customer base, its work force and its brand names. Such assets could be of
huge interest to the shareholders, but they would be difficult to value and the
valuations would be open to challenge.

The going concern concept assumes that a business will continue indefinitely in its
present form. That justifies many of the limitations imposed by the cost concept
because there is little harm in reporting irrelevant figures for value if the assets
concerned are unlikely to be sold in the immediate future.
Any two concepts are acceptable.

This question was answered very well. Usually questions on the accounting
concepts are done very well and this was no exception.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, April 2011

17 A disclaimer is an extreme form of modified audit report. Effectively the auditor

refuses to express an opinion on the financial statements because of uncertainty that is
so serious that it is impossible to form an opinion. In these circumstances, the auditor
believes that the financial statements cannot be used for decision making purposes.

This form of qualified report would be used in extreme cases where the evidence
available to the auditor is so deficient that it has led to extreme uncertainty. For
example, the auditor might disclaim opinion if the bookkeeping records had been
destroyed by a fire and no backups were available.

This question was probably the least well answered in the exam. Many candidates did not
know what a disclaimer report was. The level of knowledge of this area of the syllabus was
poor.

18 The markets are likely to read the reduction of the dividend as a sign that the company
is in difficulty. Companies always try to maintain a steady dividend policy in order to
demonstrate confidence.

The directors could attempt to limit the damage by stressing that the cash will be
invested in a positive NPV project. If the market accepts that argument then, at least
in theory, the share price may not be harmed to the same extent. The problem is that
this assurance may be misread as an excuse for cutting the dividend and may not be
fully believed or understood.

In any case, shareholders may be disadvantaged by this action because some will be
dependent upon the dividend payment.

This question was answered very well by most candidates, showing a clear
understanding of this topic.

19 (i) Gearing indicates the proportion of the long term finance provided by lenders.
If the gearing ratio is high then the banks will be competing with a larger
number of creditors for payment in the event of default. High gearing also
indicates that the company is at an increased risk of running into difficulties.

Banks often restrict the gearing ratio so that only a minimal amount of
additional borrowing is permissible. They track gearing closely in order to
check that the company is not in default because they would then have the
right to foreclose on the loan.

(ii) Gearing (original figures) = (£11m)/(13m + 11m) = 46%

Gearing (loan, unadjusted) = (£11m + 8m)/(13m + 11m + 8m) = 59%
Gearing (loan, adjusted) = (£11m + 8m)/(13m + 7m + 11m + 8m) = 49%

The calculations were done reasonably well.

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Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, April 2011

(iii) Revaluing property increases a company’s equity and so if the company has a
bank covenant in place, it may avoid the covenant conditions being breached.
The danger is that the revaluation does little to reduce the risks faced by the
shareholders and the company itself. There will be no additional cash flows
arising as a result of the revaluation and so the company will be no better
equipped to service the larger loan.

Relying on revaluation to support the a loan decision implies that a company

is willing to risk the loss of its property in order to proceed with the loan. If
that is the case then it may be of some reassurance to the lenders, but will do
little or nothing to comfort shareholders. There is no great advantage in
revaluing in order to comfort lenders because the accounting treatment does
not affect the fact that the asset’s value had increased.

This part of the question was answered quite well.

Most candidates understood that revaluing an asset would possibly help the
conditions of the bank’s covenant.

(iv) The most immediate implication from the shareholders’ point of view is that
revaluation makes the directors more accountable for the resources that have
been provided in order to generate wealth for the shareholders. When
calculating return on capital employed the revaluation reserve indicates the
full extent of the equity that has been entrusted to the board. If assets were left
at cost less depreciation then it would possibly make the company look more
efficient than it actually was.

Regular revaluations may also force the directors to ensure that they take
adequate care of the company’s assets. If they do not maintain the property or
pay attention to market trends then the shareholders may be concerned that the
company is not maintaining the property adequately or that the company is
retaining an investment in property in the face of a declining market.

This question was not answered very well as it called for application of
knowledge on revaluations. It required candidates to think carefully about
why assets are revalued and whether it is a good idea or not.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, April 2011

20 (i) Required rate = 4% + (0.55 × 9%) = 8.95%

Most candidates got this calculation correct.

(ii) The total risk associated with an investment is not particularly important in the
context of a diversified portfolio. A significant proportion of the risk in most
investments can be diversified away. In other words, factors such as the risk of
IT failure or of the closure of the roads will be cancelled by portfolio effects.

Risk can be separated into two components: systematic and unsystematic.

Systematic risk is inherent in the political and economic environment and is
common to all companies. For example, a change in energy prices will affect
all companies to some extent. Unsystematic risk is specific to the company. It
encompasses a range of risks specific to the company such as changes in
market demand for its products, stability of industrial relations, nature and
location of its assets, and so on.

Systematic risk cannot be diversified away because it arises from factors

which will have an effect on all companies. Thus, an increase in interest rates
or oil prices is likely to have an adverse effect on all companies and will
depress returns from the market as a whole. Unsystematic risk can be
diversified away and, provided the investment is held in a properly diversified
portfolio, it can therefore be ignored.

It is possible that a highly speculative investment will not be affected by

general market conditions to any great extent. That means that it will not have
a high systematic risk. The volatility will, therefore, be due to unsystematic
factors that can be diversified away. That, in turn, suggests that the investment
may require a very low return.

This question is asked in various guises quite frequently. This was not
answered very well. Candidates should study systematic and unsystematic
risk and how the theories could be applied in different cases.

(iii) In theory the share price will rise by the NPV per share from the investment.
Accepting positive NPV projects creates wealth for the shareholders and that
should be reflected in the share price as soon as the markets become aware of
the investment.

In practice, there is no guarantee that the company will release sufficient

information for the market to make this evaluation. There is a commercial cost
to releasing information and Porter will not wish to alert competitors any
sooner than necessary.

There is also the question of whether the shareholders will agree with the
board’s evaluation of this project. The degree of optimism that should be
shown is really a matter of opinion.

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Subject CT2 (Finance and Financial Reporting Core Technical) — Examiners’ Report, April 2011

The shareholders may view any information of this nature as biased and self-
serving. The directors may not be honest in terms of disclosing the risks and
costs.

This question was poorly answered with few candidates making a

connection between share prices and accepting positive NPV projects.

(iv) Company directors are in a rather different position from shareholders. A

shareholder can hold a diversified portfolio of investments and can, therefore,
reduce the risks associated with a particular investment. A director will
probably have only one principal employer and will, therefore, be motivated
more by total risk.

This different perspective might be evidenced by a tendency to invest in

relatively safe projects. This is because a disaster might be rather catastrophic
for the board even though it would have relatively little impact on the
shareholders.

If the board proceeds with this investment then there is also a risk that the
shareholders will blame the directors for any failure in the project. Their
reputations may be at stake even though the risks are known and are being
taken in a considered manner.

This part was done very poorly with few candidates making any good points.

END OF EXAMINERS’ REPORT

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 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2010 examinations

Subject CT2 — Finance and Financial Reporting

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

T J Birse
Chairman of the Board of Examiners

December 2010

© Institute and Faculty of Actuaries

 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2010 — Examiners’ Report

1 C
2 C
3 C
4 B
5 B
6 D
7 D
8 B
9 C
10 B

11 Overdraft facilities are repayable on demand. If the facility is not managed properly
then there is a risk that the bank will demand immediate repayment and that could
have severe consequences for the company. The bank might also use the overdraft
facility as a means of monitoring the business’ financial health and any excessive
reliance could undermine the business’ credit rating. It is also undesirable to use
overdrafts extensively because they are very expensive. It would be preferable to use
a short term loan to replace the overdraft. Doing so would also free some of the
overdraft facility to provide cover for contingencies.

12 Tax systems often focus more heavily on income rather than wealth, which means that
taxpayers are more likely to be asked to pay a tax bill that is based on cash flows
rather than other assets that might not be liquid. Tax charges are usually levied in
arrears, so that the income has been earned before it is taxed. Tax systems often
attempt to ensure that income is taxed only once, for example double tax relief
reduces the chances of the same income being taxed by two separate regimes and
similarly imputation systems are often designed to ensure that income tax is not paid
on dividends that are paid out of profits on which corporate tax has been paid.
Tax systems also tend to feature tax free allowances and also accelerating rates, which
makes them progressive and means that those who can afford to pay at a higher rate
actually do so.

13 The main reason for paying a higher rate is that Eurobonds are issued outside of any
legal jurisdiction. That lack of regulation increases the risk to the lender. Eurobonds
tend to be unsecured, which increases the risk even further. Eurobonds are traded
through banks rather than stock exchanges, which further reduces the scope for
regulation. Eurobonds tend to be used to raise large amounts of money, and so a
higher rate will make it easier to ensure that the issue is taken up.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2010 — Examiners’ Report

14 There are qualitative factors that should be considered. For example, the life of
borrowing should ideally be matched to the maturity of the associated assets. A
medium term loan taken out to finance long term assets might have to be serviced out
of cash flows from other projects.

Some companies need to have the flexibility to draw down funds when needed but
repay loans when activity tails off. That type of facility will also be a factor in
deciding whether the debt that has been borrowed is of the correct nature for the
business.

There may be times when the risks associated with gearing are dwarfed by the risks of
standing still and not borrowing in order to adapt to changing circumstances. The
gearing ratio does not necessarily reflect the company’s appetite for funds.

15 Managing project risks should take account of far more than the expected value of the
risks. For example, the 20% risk is fairly likely to occur and its effects will not be
catastrophic if they do. In that case, it would make more sense to accept the risk
provided the NPV from the project offers sufficient compensation for the risk of
losing £1m. The high probability of occurrence probably means that any alternative
approach would be too expensive to consider.

The 1% risk is potentially catastrophic because it would erode 20% of the company’s
capitalisation. The low probability of occurrence probably means that it would be
possible to hedge or insure in some way so that the risk can be avoided. If that is the
case then the cost of the insurance will be taken on board in evaluating the project.

16 (a) If the share price falls then the market is effectively demanding that the profits
earned by the company are capitalised at a higher rate of return. In other
words, the cost of equity is increasing.

(b) If the share price is declining then there is a need to find positive NPV projects
in order to halt the decline, but the board has to ensure that the cost of equity is
at least met by these prospective investments. It may be that the directors have
to cancel some projects that had previously been planned or reject proposals
that would once have been funded.

The communication of the risks and rewards may also have to be managed
more carefully. Management may have to convince shareholders that they are
achieving good value from their investments.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2010 — Examiners’ Report

17 The most immediate implication might be that market forces would discipline the
company quite severely. Shareholders and other users might feel that the use of
unacceptable accounting policies meant that the directors had something to hide,
which would push share prices down and could push up interest rates. Some lenders
might argue that the company is technically in default of debt covenants based on
accounting numbers and they might even foreclose on the company.

There could be more direct action by regulators such as the stock exchange or other
regulators.

18 The stock market sifts information carefully to ensure that it does not misprice
securities. If shares are overpriced then there will be opportunities for astute market
participants to make profits by identifying the overpriced companies and selling
shares (possibly short). Market forces would push the shares down and these activities
would also draw attention to the distortion.

Much of the optimism in making accounting choices is quite visible. For example,
companies publish their accounting policies and so it is possible to tell whether a
particular approach has been followed.

19 (i)

Real PLC
Forecast Income statement for the year ended 31 December 2010

£000
Revenue 20,000
Cost of sales (12,600)
Gross profit 7,400
Distribution costs (1,200)
Administrative expenses (400)
Operating profit 5,800
Finance costs (712)
Net profit before tax 5,088
Tax expense (1,500)
Profit for the year 3,588

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Subject CT2 (Finance and Financial Reporting Core Technical) — September 2010 — Examiners’ Report

Real PLC
Forecast balance sheet as at 31 December 2010

£000
ASSETS
Non-current assets
Property 10,000
Plant and equipment 13,400
Total non-current assets 23,400

Current assets
Inventories 1,500
Trade receivables 1,667
Bank 10
3,177
Total assets 26,577

EQUITY AND LIABILITIES

Equity
Share capital 10,000
Retained earnings 3,997
Total equity 13,997

Non-current liabilities
Long-term borrowings 10,000

Current liabilities
Trade payables 1,000
Accrued interest 80
Current tax payable 1,500
2,580

Total liabilities 12,580

Total equity and liabilities 26,577

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2010 — Examiners’ Report

(ii)

Original figures With investment

Profitability
Return on capital employed 6,400/(14,677+6,000) = 31% 5,800/(13,997+10,000) = 24%
Gross profit percent 8,000/20,000 = 40% 7,400/20,000 = 37%
Liquidity
Current ratio 2,177/2,500 = 0.9:1 3,177/2,580 = 1.2:1
Quick ratio 1,677/2,500 = 0.7:1 1,677/2,580 = 0.7:1
Efficiency
Inventory turnover 500/12,000 × 365 = 15 days 1,500/12,600 × 365 = 43 days

Making this initial investment will increase the recorded cost of depreciation
because of the company’s policy of charging a whole year’s cost when an
asset is new and also increase the cost of interest because of three months’
interest on the new loan. The reduced profit combines with the increased
capital employed to yield a much lower return on capital employed. Overall,
the company seems much less profitable than it would without the investment.

The company’s liquidity will be affected by the increase in inventory, which

has the effect of making the current ratio appear higher and less efficient. That
combines with the much slower apparent inventory turnover to make the
directors look as if they are not properly managing inventory.

If the directors do undertake this investment then they will have to ensure that
the shareholders are adequately informed that the figures have been affected
by the need to put the funding in place for the new project and also by the
decision to install equipment and stockpile inventory ready for the start.

(iii) A year can be a very short period for a business that has a profit cycle of
several years. For example, it might take three years to research a new
product, which will then sell strongly for five years before becoming less
popular. The danger is that profits will be depressed during the research phase
of that cycle. If the directors do not trust the shareholders to appreciate the
reasons for that then there is a risk that they will not invest adequately in
development.

The same problem can arise with any investment programme. If the initial
investment is made part of the way through the year then the balance sheet
will show the closing position on capital employed and the directors will
appear to have had those resources at their disposal when returns are being
evaluated. The project may not have started during the year or it may have
been in operation for only a short part of the year and so ratios such as return
on capital employed will make the company seem inefficient.

20 (i) The venture capitalist will have a very similar interest in the survival of the
company as the founder. A lender might be prepared to put the company out
of business, but a venture capitalist may lose everything in that case. The

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Subject CT2 (Finance and Financial Reporting Core Technical) — September 2010 — Examiners’ Report

venture capitalist’s equity will also leave scope for borrowing if required,
thereby providing scope for greater flexibility in seeking fresh funding.

The venture capitalist is likely to seek an exit route in the medium term to
release funds that can be reinvested elsewhere. That could mean that the
company has to fund a major outflow at a crucial stage of its development.

The other major problem is that the venture capitalist will be looking for a
realistic price for the shares when they are bought out. If the company has
prospered then the cost of releasing the equity may be prohibitive.

(ii) Share options give the directors an incentive to maximise the share price. That
may have the effect of bringing their interests into line with those of the
shareholders. The directors will have an incentive to work hard and use their
ingenuity in order to create wealth for the company.

There are some dangers with options, though. The directors will need the share
price to exceed the strike price before the options expire. That could give them
an incentive to push the company’s growth too quickly or even to distort the
share price by manipulating the financial statements. The options also expire
worthless, so the directors will have very little to lose if the options are out of
the money and they decide to take a major risk. If the risk pays off then the
options will be in the money and if not then the options would have been
worthless anyway, but that will be of no consequence to the shareholders.

The value of the options will be enhanced if the company’s share price
becomes more volatile. The shareholders might prefer a less volatile (i.e. less
risky) investment.

(iii) The auditor is appointed by the shareholders and reports to the shareholders.
The external auditor has no specific duty to protect the shareholders interests.
The auditor forms an opinion on the truth and fairness of the financial
statements and reports that to the shareholders. If there are material concerns
about the financial statements then they should be reported to the shareholders
in the audit report.

The purpose of the audit is to ensure that the shareholders have a credible
source of accounting information that they can use to make stewardship
decisions. The auditors do not claim to identify badly run or unprofitable
companies. It is up to the shareholders to make such decisions for themselves,
informed by the audited financial statements as they deem appropriate.

END OF EXAMINERS’ REPORT

Page 7
Faculty of Actuaries Institute of Actuaries

EXAMINERS’ REPORT

April 2010 Examinations

Subject CT2 — Finance and Financial Reporting

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

July 2010

Comments

These are given in italics at the end of each question.

© Faculty of Actuaries
© Institute of Actuaries
Subject CT2 (Finance and Financial Reporting Core Technical) — April 2010 — Examiners’ Report

1 B
2 A
3 D
4 D
5 A
6 A
7 A
8 C
9 A
10 A

Questions 1–10 were answered well by most candidates.

11 (a) Information asymmetry arises because the directors know more about the
management of the company than its shareholders. The directors can also have
greater confidence in the figures at their disposal because they can check the
underlying data and the manner in which the information has been prepared.

(b) Financial reporting is a vital part of assuring the shareholders that the
company is being managed properly and in their best interests. The directors
will normally be keen to signal that the figures have been prepared accurately
and in accordance with acknowledged accounting standards. Publishing
credible financial statements will simplify the process of dealing with
shareholders.

The external financial statements are likely to be subject to an independent

external audit to further enhance the credibility of the accounts.

Part (a) was answered poorly with many candidates not showing any understanding of the
term at all, however part (b) was answered very well with most candidates scoring high
marks.

12 (a) The discount arises because the investment trust will charge an annual
management fee. The net present value of that should be deducted from the
underlying assets held by the trust in order to establish the investment trust’s
true value to the shareholder. It is also possible that the investment trust will
be slightly less marketable than the large quoted companies in which it has
invested and so the discount will be increased still further. Other reasons may
include natural sellers, aging population, illiquidity and a proliferation of
similar investments.

(b) The discount should not deter investors. If they buy existing shares in an
established investment trust then their initial investment will take advantage of
the discount. Even if they buy directly from the company it will be more
practical for an investment trust to spread the risk and diversify than it would

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2010 — Examiners’ Report

be for many individual investors. Furthermore, the investment trust will

provide management expertise that will either reduce the risk of a costly
mistake or will offset the cost of paying for advice. Other reasons include
lower total expense ratios, audited accounts requirements, a wider range of
investment specialisms and gearing

This question was answered well by many candidates.

13 Warrants provide lenders with an opportunity to enjoy future increases in the share
price. That is a valuable benefit that can be added to the interest earned from the loan
stock, so the interest rate charged can be reduced. That will save cash and provide the
company with a better cash inflow in order to finance growth. The benefit will be
enhanced by the fact that the downside risk is restricted to the relatively small value
that will be attached to the warrant. The lender’s principal will almost certainly be
secured and so outright loss is highly unlikely.

The main problem faced by the shareholders is that the warrants will dilute their
equity in the event that the lenders exercise their rights to buy shares. If the project is
successful then the lenders will share in the gain and so the shareholders will earn less
from taking the ultimate risk.

Some candidates appeared not to know what warrants were while others gave a very
complete answer.

14 A rights issue is targeted at shareholders who have already demonstrated their

willingness to invest in the company. That reduces the cost of promoting the issue and
identifying suitable investors.

If the shareholders do not wish to take up their rights then the rights themselves have
a value and the shareholders have an incentive to sell them. The buyers are likely to
take up the right to subscribe to the offer, which reduces the need to underwrite the
issue.

The fact that the rights issue automatically compensates the shareholders for the
effects of the discount means that it is generally an equitable and acceptable method
of generating fresh equity. That makes rights issues more acceptable to the stock
market than other methods for an established company to issues further shares.

This question was answered very well by most candidates.

15 The basis on which the simulation has been prepared and tested should be studied
closely. The apparent success rate could be due to an error in the specification of the
model.

The results in the 15% of the time that the project returned a negative net present
value must be studied closely. Is there a significant downside risk that should be

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2010 — Examiners’ Report

considered? A project that carries a realistic probability of the company being forced
into liquidation might be best avoided even if it has a significant probability of
success.

The anticipated income from the project should also be taken into account. If the
likely NPV is a small positive then that might not be sufficient to justify the
possibility of a loss.

Ultimately, the directors should consider the distribution of likely outcomes rather
than simply look at the most likely.

This question was answered very well by most candidates.

16 The cash flow statement indicates how the company has managed inflows and
outflows of cash during the year. A comparison of the opening and closing balance
sheets will indicate whether the company has more or less cash at the end of the year
than at the beginning, but that comparison does not indicate what has happened in
order to bring about that increase or decrease. The cash flow statement shows how the
company has both generated cash receipts and made payments.

The cash flow statement also indicates an important performance measure. Arguably,
it is more important to generate profit than to earn cash, but profits are not sufficient
to keep a business afloat unless they are backed by net cash receipts. A profit can be
recognised long before the company has any cash to show for it and the company will
have to meet its commitments in the period before the cash is actually received.

This question was answered poorly by some candidates. Candidates appeared not to
have learnt the format of the cash flow statement.

17 There is a general requirement that the financial statements give a true and fair view.
Amongst other things, that any treatment gives a realistic and representative treatment
of the transaction. It cannot be accounted for in a flattering way just because it is not
the subject of a specific regulation.

In the UK, FRS 18 gives some guidance as to how the policy should be selected. For
example, the objectives of relevance, reliability, comparability and understandability
should be applied.

The directors might consider looking at the treatment laid down by standards for
similar balances, even though those standards might not be strictly applicable. That
would ensure that the logic underlying the chosen treatment was consistent with good
accounting practice.

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2010 — Examiners’ Report

18 Preparing financial statements involves making estimates and assumptions. For

example, inventory is valued at the lower of cost and net realisable value. The
directors can bias such assumptions towards maximising profit without doing so to the
extent that any dishonesty can be proven.

The selection of accounting policies is subject to accounting standards, but there are
often cases where the transactions or balances are not directly governed by any
specific standard. For example, the recognition of revenue can be quite a difficult area
of accounting. The board could start to recognise profits at a time that can be justified
without that necessarily being the most appropriate in terms of good accounting
practice.

This question was answered poorly.

The accounting policies are a common question. Generally the more theoretical questions
were not answered as well as questions involving calculations.

19 (i) The book value of property, plant and equipment would increase, as would the
revaluation reserve.

Property, plant and equipment would be increased to £200m+90m = £290m.

The revaluation reserve would be £90m.

(ii) Gearing (original figures) = (£50m+30m)/(161m+50m+30m) = 33%

Gearing (with revaluation) = (£50m+30m)/(161m+90m+50m+30m) = 24%

(iii) The revaluation means that the company would be in technical compliance
with the covenant. However, the purpose of the covenant is to ensure that the
company’s borrowings are manageable and that the interests of the lenders are
not prejudiced. The revaluation has the effect of altering the figures from
which gearing has been calculated, but that does not generate any additional
cash from which to meet the company’s commitments.

Borrowing heavily, using the revaluation of assets as a basis for doing so, will
threaten the equity invested by the shareholders. The more heavily that the
company borrows the greater the risk that the company will be unable to meet
its commitments. If the company goes out of business then the assets that have
been revalued may have to be sold under duress and that might mean that the
revalued sum will be impossible to realise.

It would be more satisfactory for the directors to decide that the company is
already heavily geared and seek some way to generate additional funds from
equity.

(iv) The revaluation of assets gives shareholders a more realistic impression of the
resources that they have placed at the disposal of the directors. That gives
them a clearer impression of the performance of their board in generating
wealth from the company’s assets.

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2010 — Examiners’ Report

Revaluation should also give a clearer indication of the assets that will actually
be available in the event that the company runs into difficulty. Keeping the
assets at their valuation may be helpful to potential lenders when evaluating
the assets that have been pledged as security.

Valuation increases the subjectivity in the financial statements. Any valuation

is only ever an opinion as to how much the assets are actually worth, but the
validity of that assumption can only be tested by selling the asset and seeing
whether it can be sold for that amount.

Valuing assets also introduces some volatility into the balance sheet because
the valuations must be kept up to date. The asset may have to be written down
if market prices fall.

In general the larger questions were answered poorly compared to the shorter questions.

Part (iii) was answered well by many candidates. Part (iv) was answered very badly with
some candidates not doing this part of the question.

20 (i)

Time 0 1 2 3 4 5
Revenue 2.6 2.6 2.6 2.6 2.6
Machine (4.0)
Factory deposit (0.1) 0.1
Lease payment (0.2) (0.2) (0.2) (0.2) (0.2)
Inventory (0.4) (0.4) (0.4) (0.4) (0.4)
Labour (0.3) (0.3) (0.3) (0.3) (0.3)
Running costs (0.5) (0.5) (0.5) (0.5) (0.5)
Dismantling (0.3)
Cash flow (5.0) 1.2 1.2 1.2 1.2 1.9

Discount factor 1.000 0.935 0.873 0.816 0.763 0.713

Discounted cash flow (5.0) 1.1 1.0 1.0 0.9 1.4

Net present value = total = £0.4m

Cash flows
Discounted cash flow
NPV

(ii) The cash flows should be assessed in terms of the risk attached to the project.
The risks borne by the company and its shareholders are not mirrored by those
borne by the lender. The risks to the company are based on the possibility that
the project will not generate a satisfactory return in line with expectations,
which has nothing to do with the risk that the bank will not be repaid on time

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2010 — Examiners’ Report

or in full. The bank will secure its advance against the company’s other assets,
which will increase risks to the existing providers of finance. The loan will
push up the cost of equity and so the real cost of the finance to the company
will be higher than 7%.

(iii) Tax will reduce the net cash inflow from the project.

The timing of payments will also be affected because tax is often paid for in
arrears, which means that the tax bill for year 5’s profits will probably be paid
in year 6. That might mitigate the effect of the additional outflows arising
from the tax on profits from the project.

Tax calculations will complicate the analysis and increase the risk associated
with the figures. There is a possibility that the tax authorities will not agree
with the tax calculations prepared by the company and that some expenses will
not be permitted. The time spent negotiating the tax bill will create additional
outflows for professional fees and may also prove to be a distraction from
other projects.

Allowing for tax may affect the cost of capital because tax relief will be
obtained on the loan.

This question was answered badly by many candidates. The main difficulty was part (i)
where candidates did not understand what a cash flow was or what should go into it.

It should only have items that involve the movement of money.

Parts (ii) and (iii) were answered a little better but were still poor.

END OF EXAMINERS’ REPORT

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Faculty of Actuaries Institute of Actuaries

Subject CT2 — Finance and Financial Reporting

Core Technical

September 2009 examinations

EXAMINERS’ REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

December 2009

Comments for individual questions are given with the solutions that follow.

Faculty of Actuaries
Institute of Actuaries
 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2009 —Examiners’
Report

The results were somewhat disappointing this time as the paper seemed to be of the same standard as the
previous diet. Many answers were very brief and lacked substance. The worst section was probably the short 5
mark questions , some of the answers to theses were very poor.

Candidates should study the whole syllabus so they can attempt each question, it is a dangerous strategy to only
study some topics and expect to be able to make general comments for the rest of the questions.
Question 19 was done very well and is clearly a topic that candidates find straightforward which is very good.

1
The answer was A

2
The answer was D

3
The answer was B

4
The answer was A

5
The answer was D

6
The answer was D

7
The answer was C

8
The answer was A

9
The answer was A

10

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2009 — Marking
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The answer was D

The MCQs were done very well by most candidates which was excellent and very heartening.

11
A finance lease will normally last for the useful life of the asset. The lessee will bear the risks of the
asset becoming obsolete during its lifetime or of it becoming surplus to requirements. As with a loan,
the cash flows will, presumably, be sufficient to enable the lessor to recover the cost of the asset
effectively with interest. The lessor will have the same rights to repossess the asset as a lender who had
secured a loan against the asset.

From an accounting point of view, a finance lease is accounted for as if the asset had been purchased
outright with a loan.

The answers to this question were usually very superficial. The most common mark was a marginal
fail. Candidates should try to go into more detail in their answers.

12
Taxpayers may pay income tax at a higher marginal rate than the rate at which capital gains are taxed.
Many taxpayers will have an unused allowance for capital gains. These factors combine to make capital
gains tax less expensive than income tax for most taxpayers.

Capital gains are not normally taxed until the gains are realised, whereas income is taxed when it is
earned. That means that there can be a lot more scope for planning the timing and payment of capital
gains tax. Transactions can be brought forward or delayed to recognise a gain in the most suitable
period.

This question was answered well with most candidates being well versed in capital gains tax.

13
The biggest advantage is that the penalties for any failure are less severe. The capital may not be
repayable or redeemable, unlike a loan which is likely to be for a finite period. The dividends may be
equivalent to interest, or even higher, but the penalties for any failure to pay the dividend are likely to
be no worse than the company being forbidden to pay an ordinary dividend. In some cases, any unpaid
dividends will be foregone and the company will have no ongoing commitment to pay these when it
returns to profit.

Preference shares rank behind all liabilities in the event of failure. Thus, lenders will be happier to see
preference shares issued rather than additional borrowing.

Some corporation tax payers can enjoy a higher return after tax from preference shares than from loan
stock, thereby making it cheaper to issue preference shares to them.

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This question was done reasonably well, again a little more detail would have improved the answers.
Most candidates showed good knowledge of this topic which was great.

14
A property company can offer a lender security against its assets. That means that a lender would be
less concerned about the risk of default because the collateral should ensure that the capital will be
repaid.

A property company is also likely to raise a steady stream of income from tenants. That means that it
can take on higher borrowing because it knows that it will be able to service them from rental income.
The investment in property is likely to yield a steady capital gain over the long term, with a relatively
low risk. The returns are unlikely to be high and raising funds from borrowing will be cheaper than
using equity.

The answers to this were very vague and waffly. Not a topic that was understood by the majority of
candidates. This was surprising. Answers were just too general.

15
Calculating depreciation depends on major assumptions. The company has to estimate the useful life of
the asset and the residual value. Both figures are subject to massive uncertainty. For example, useful
life can be affected by physical characteristics such as wear and tear, by technical issues such as the
possibility of obsolescence and even by commercial factors such as the possibility that demand might
change and leave an asset worthless.

The company must also decide how the difference between cost and residual value should be written
off. For example, the choice between straight line and reducing balance depreciation can significantly
affect the annual depreciation charge.

This question was fairly straightforward and was done badly by many candidates. The question did not
ask how to calculate depreciation which is what many candidates answered. This approach got low
marks. Candidates must read the questions carefully and make sure they answer what is asked.

16
Capital project appraisal normally involves deciding on the shareholders' behalf whether an investment
should be undertaken. That involves having a decision rule such as NPV or IRR and investing in
projects that best meet the criteria.

The shareholder value approach takes account of how that project will be received by the shareholders
and markets. In theory, any positive NPV project should enhance shareholder value, but the
shareholders will not have all of the information available to the directors. Even if they had, they would
not necessarily process that information in the same way. The directors have to consider how news of
the project is likely to be received by the markets. That might involve considering how the indicators
used by shareholders might be affected, such as the EPS or dividend.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2009 — Marking
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This question was answered well. Project appraisal is a topic that candidates had studied and gave
good clear answers which is hearening.

17
The money measurement concept means that the financial statements only reflect those assets that can
be valued objectively in monetary terms. This means that the balance sheet may well exclude extremely
valuable assets such as customer loyalty. It is highly unlikely that it would be possible to buy the
company without paying for such assets, with their value being determined by a process of negotiation
between the buyer and the seller.
Consolidation implies the acquisition of a controlling interest. It might be sensible to pay more than the
book value in order to obtain control if the buyer feels that a change of management would enable the
company to perform more effectively. Individual shareholders would normally expect the buyer to pay
a premium for control and so the share price will tend to rise when the possibility of a takeover is
announced.

This question was not done very well. Many candidates gave very vague low level answers which got
low marks.It was clear that many candidates were just making up a general answer and had very little
idea about this area.

18
The external auditor’s primary role is to express an opinion on the truth and fairness of the published
financial statements. This is necessary because these statements are used to resolve many of the agency
issues that arise between the directors and the shareholders. The shareholders can only rely on the
statements if they can be satisfied that the financial statements have not been distorted or manipulated
by the directors. The auditor gathers evidence on the accuracy of the information in the bookkeeping
records and examines the accounting policies used in the preparation of the financial statements. A
clean audit opinion is not a guarantee, but it does give the readers some reassurance that the statements
have been prepared properly and are a credible basis for making decisions.

This question was done very well by most candidates which was excellent.

19
(i)

2009 2008

Profitability

Return on capital employed 4,368/(4,816+6,934) = 37% 2,910/(4,100+2,675) = 43%

Gross profit percent 5,040/8,400 = 60% 3,180/6,000 = 53%

Distribution costs/sales 504/8,400 = 6% 180/6,000 = 3%

Revenue/fixed assets 8,400/12,000 = £0.70 6,000/7,000 = £0.86

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Risk

Gearing 6,934/(4,816+6,934) = 59% 2,675/(4,100+2675) = 39%

Current ratio 990/1,240 = 0.8:1 745/970 = 0.8:1

Quick ratio 710/1,240 = 0.6:1 510/970 = 0.5:1

At first glance, the company seems to have boosted revenue and profit. The move to a new range of
products has boosted the gross profit percentage. The company has, however, become less profitable
because return on capital employed has declined. This decline appears to have arisen because of the
investment in machinery. Each £1 of machinery generated £0.70 of revenue, which is rather less than
the £0.86 that was generated in 2008. Another factor is the doubling of the percentage of revenue spent
on distribution. The new product range may require a greater sales effort.

The important question to ask is whether this is a transitional period. If the company only installed the
equipment during the year and then operated it at less than full capacity then the return on capital
employed and revenue to fixed assets ratios will both be artificially depressed.
The risks have also increased significantly. Gearing has gone up from 39% to 59%, thereby increasing
any volatility to the shareholders. The liquidity ratios are low, although that may be less of a problem
because the company had a similar set of liquidity ratios in 2008 and it has survived since.

(ii) The main problem with the annual report is that it provides only limited amounts of detail. It would
be extremely useful to have had a full analysis of the new venture in the annual report, but none would
have been provided. Companies are reluctant to publish information that could be used by their
competitors. It would be useful to know how management feels that the new product will develop over
time, but such predictions are fraught with difficulties. If management is over pessimistic then the
shareholders might question the wisdom of the investment, but optimism could lead to disappointment
and an overreaction if things do not work out.

Some of the information in the annual report will also date very quickly. For example, the liquidity
position will change from day to day.

This question was done very well by candidates which was excellent.
The calculations were excellent in most cases but the written explanation was usually brief and lacking
substance. The calculations pulled the marks up and made this one of the best answered questions.

20
(i) This investment is a major strategic decision. It is not really sufficient to set a single criterion for
this and then analyse the project because the decision is far more complicated and requires a far richer
analysis. This decision has the capacity to cause the company a great deal of harm if its implications
are not thought through and managed.

(ii) There are many different frameworks that can be used to analyse this proposal. The following
categories of risk should be considered:

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2009 — Marking
Schedule

Political The government in the home country might be rather disturbed by the fact that it is
outsourcing production. The local government might also be concerned about the implications of
relying on multinational corporations for employment. Either government could act against the
company’s interests, either through legislation or through the activities of government departments
such as the tax authorities.
Business The company seems to be very strongly identified with the home country. The brand’s
popularity might decline as a result of the move offshore.

EconomicManufacturing in one country for sale in another will create a series of currency risks that did
not arise before. If the economy of the new location is weak then there could be problems with
inflation.

(iii) Individuals have their own personal risk preferences. The “rational” analysis of an investment
project often uses market prices and thereby uses norms set as an average by the market as a whole. Ms
Lee could easily be more risk averse than the average investor.

Ms Lee does not have a balanced and diversified portfolio. She will be exposed to the total risk,
whereas market preferences are often arrived at using portfolio theory.

There are non-economic issues that could affect her decision. She may have a sense of attachment to
the original business model and might be unwilling to change that unless there is a significant reward
for doing so.

(iv) The biggest advantage of seeking a quotation is that all parties will have a clear exit route. The
venture capitalist will be able to sell their stake on the open market and move on. Ms Lee will be able
to scale down her stake in the company.

The quotation will make it easier to seek fresh equity in the future.

There are potential disadvantages. Seeking the quotation will be an expensive matter. The company
will have to invest heavily in professional fees, underwriting, etc. Ms Lee will also have to sacrifice a
great deal of control of the company. She may be able to remain the largest shareholder, but will not be
able to retain a majority shareholding. She will be answerable to a body of shareholders who may have
a different attitude towards the way in which the company should be run.

Answers to this question were generally poorer than expected. Some parts were very weak.

Part i was poor and should have been straightforward. Part ii was not as bad but some candidates had
difficulty identifying suitable risks.

Part iii was done well by some candidates but weaker candidates were poor in this part also. More
detail was required to get a good mark in this part of the question. Part 4 was reasonable but again
many candidates scored a borderline fail mark as they did not have much detail in their answer.

END OF EXAMINERS’ REPORT

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Page 8
Faculty of Actuaries Institute of Actuaries

Subject CT2 — Finance and Financial Reporting

Core Technical

EXAMINERS’ REPORT

April 2009

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

June 2009

© Faculty of Actuaries
© Institute of Actuaries
Subject CT2 (Finance and Financial Reporting Core Technical) — April 2009 — Examiners’ Report

Comments

This paper was generally done fairly well by candidates which is reflected in the better pass
rate achieved for this diet.

The marks were better than the previous diet which is excellent.

Most questions were done well by candidates. The poorest answers were for the last question
on risk. Candidates can do the calculations well but have difficulty answering questions
about them.

Some revision of that area is required.

It is heartening to see an improvement in the standard of answers, hopefully this will continue
in the future.

Where relevant, comments for individual questions are given after each of the solutions that
follow.

1 B
2 A
3 C
4 D
5 C
6 D
7 D
8 D
9 A
10 B

Working for question 10:

A = 500 / (200 + 450)

B = 600 / (200 + 450) = quick ratio
C = 600 / 450
D = (500 + 600) / (200 + 450) = current ratio

Questions 1 to 10 were done well by most candidates.

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2009 — Examiners’ Report

11 In theory, incorporating as a limited company would restrict all claims to the

company’s assets. In theory, the worst that could happen would be for the two
actuaries to lose everything that they have invested in the company.

In practice, it is unlikely that a lender would be so naïve. The company’s assets are
unlikely to amount to much as security for any loan. The rental deposit will probably
go to the landlord to pay any rent arrears if the company fails, the IT equipment will
have very little second hand value and the money spent on running costs will have no
residual value.

Any rational lender is likely to demand a personal guarantee from the two actuaries as
a condition of granting the loan. Incorporation is only likely to protect the actuaries
from smaller creditors who did not take the precaution of seeking a guarantee.

This question was done reasonably well by candidates. Few candidates mentioned a
personal guarantee which was surprising, but on the whole many good answers were given to
this question.

12 The tax authorities do not wish to give companies too much discretion over the
calculation of their taxable profit. The figure for depreciation can be affected by a
host of estimates and assumptions about asset lives and residual values. This means
that taxable profit would be open to manipulation in the event that the company felt
that the tax charge would otherwise be too high. It would be difficult, if not
impossible, to prove that an estimated useful life for depreciation purposes was too
short if the company appeared to be overstating depreciation. Even if the tax
authorities had the power to challenge such assumptions, this would lead to a great
deal of time and energy being directed towards checking and negotiating assumptions.

The rules for the calculation of capital allowances may be unrealistic in terms of their
estimates of residual values or asset lives, but they remove the element of subjectivity
from the process.

This question was not done especially well. Candidates discussed all they knew about tax but
did not focus on what was being asked. There was little discussion on the problem of asset
lives and the lack of subjectivity in the capital allowance calculation.

Many candidates wasted time by discussing the different methods of calculating depreciation.

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2009 — Examiners’ Report

13 Debenture stock is normally backed by assets which reduces risk. Likewise,

debenture holders are usually preferred creditors and have either a fixed or floating
charge over assets.

The value of debentures will fluctuate in line with prevailing interest rates. If interest
rates rise then the cash flows from the debenture will be worth less because they will
be discounted at a higher rate.

Debentures might not be particularly liquid investments. Even if the company is

quoted it may prove difficult to find a buyer to close out a position.

Debenture stock is subject to the same inflation risk as other fixed interest securities.

This question was generally done well by candidates.

14 It is unclear whether any particular dividend policy is better than the others.
Modigliani and Miller (MM) argue that shareholders can achieve their own desired
dividend policy and thereby render the dividend decision irrelevant.

Dividends are, however, a major signal of management’s confidence. Any

disturbance of a steady stream of dividends may be very difficult to manage. It may
be the absolute value of dividends that matters, but the policy adopted by management
may affect the volatility of dividend payments.

Even MM acknowledge that there may be a tax element to shareholders’ preferred

dividend strategies. Any shift in policy could affect shareholders who prefer income
to capital gains or vice versa and hence affect the share price.

This question was poorly attempted by a number of candidates. The tax effect was ignored
and there was no mention of theory.

That left candidates with little to say and several candidates missed this question out.

15 Managers often have their own personal agendas in running departments, divisions or
business segments. A manager might wish to attract capital investment in order to
build a personal empire in the quest for promotion or greater recognition within the
organisation. Optimistic capital investment proposals will be more likely to attract
funding and so optimism may be in those managers’ personal interests.

Not all managers behave in this way. Some are motivated more by loyalty to the
company than by their own personal ambitions. Thus, senior management cannot
necessarily distinguish borderline projects that should be rejected because of
excessive optimism from those that have been evaluated in a conservative manner.
Ultimately, it may take several years to detect undue optimism on the part of
particular managers.

This question was answered well by candidates which was excellent.

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2009 — Examiners’ Report

16 Accounting statements provide an important basis for the shareholders to monitor and
control the behaviour of their directors. That creates a great deal of pressure for the
directors to manipulate the figures through the use of inappropriate accounting
policies. The standard setting system is intended to reduce the numbers of acceptable
treatments for specific accounting issues, with a view to standardising those
treatments in use.

Standards should enable shareholders to have greater confidence in the figures and so
they should reduce some of the problems of resolving agency issues. Thus,
companies should find it easier to raise equity because shareholders will have grater
confidence in the information being provided to them.

The standard setting process also enhances the credibility of the accountancy
profession. Society may lose confidence in accounting statements in the wake of
accounting “scandals” and anything that can be done to prevent those from occurring
will only enhance the profession’s standing.

This question was answered well by most candidates. Most candidates managed to come up
with enough reasons for having accounting standards to get a good mark for this question.

17 The directors might bias any estimates or assumptions in order to improve the
impression created by the published figures. For example, closing inventory has to be
valued at the lower of cost and net realisable value, with profit being affected by this
valuation. An optimistic assumption about the net realisable value of every item in
inventory will boost profits.

It may be possible to time transactions so that profits are enhanced. For example,
offering discounts towards the year end to encourage customers to enter into contracts
sooner than they might do otherwise would boost profits for the present year at the
expense of the next.

Timing major capital transactions might also enhance the profitability figures.
Delaying the acquisition of non-current assets may reduce capital employed by
enough to more than compensate for the reduction in activity due to the weaker asset
base.

Companies may indulge in creative accounting practices by looking for loopholes in

accounting standards that permit the reporting of higher profit figures.

This question was done reasonably well by many candidates , however some could not think
of any examples to illustrate the points they had made. Good examples will always enhance
an answer so it is worth trying to think of some in advance when revising.

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2009 — Examiners’ Report

18 In theory, maximisation of shareholder wealth offers a simple and effective objective

for evaluating managerial decisions. It is easy to justify the selection of a measure
than increases shareholder wealth because it is clearly in line with shareholders
objectives, and even allows for the interaction between risk and return.

In practice, it may be difficult to envisage the directors acting in this way. There are
many ways in which maximising shareholder wealth could be against the directors’
best interests. For example, shareholders can diversify risks in ways that directors
cannot and so directors may be more risk averse in decision making than shareholders
would prefer. Many directors have sufficient integrity to overcome any such
pressures, but it will be difficult to distinguish them from those who have not.

This question was answered well by many candidates. Most agreed that maximising
shareholder wealth was the main objective for companies. This is a generally accepted
position and most other arguments are not valid.

19 (i)

Maker plc
Income Statement
for the year ended 31 March 2009
£m
Revenue 1,200
Cost of sales (670)
Gross profit 530
Distribution costs (168)
Administrative expenses (66)
Operating profit 296
Finance costs (120)
Profit for the year 176

Maker plc
Balance sheet
as at 31 March 2009
£m
ASSETS
Non-current assets (note 1) 1,228

Current assets
Inventories 16
Trade receivables 140
156
Total assets 1,384

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2009 — Examiners’ Report

EQUITY AND LIABILITIES

Equity
Share capital 220
Revaluation reserve 164
Retained earnings 342
Total equity 726

Non-current liabilities
Loan 600

Current liabilities
Trade payables 52
Bank overdraft 6
Total current liabilities 58

Total liabilities 658

Total equity and liabilities 1,384

Notes

(1) Non-current assets

Net book
Cost/valuation Depreciation value
£m £m £m
Factory 700 (14) 686
Machinery 580 (218) 362
Delivery vehicles 380 (200) 180
1,660 (432) 1,228

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2009 — Examiners’ Report

Workings

Depreciation
Delivery vehicles (380–140)*25% = 60
Factory 700*2% 14
Machinery 580*10% 58

Cost of sales
Depreciation – factory 14
Depreciation – machinery 58
Manufacturing costs 34
Raw materials 440
Wages 124
670

Distribution costs
Depreciation - vehicles 60
Vehicle running costs 80
Wages 28
168

Administration
Expenses 24
Wages 42
66

Revaluation reserve
Cost 600
Depreciation (64)
Book value 536
Valuation 700
Gain 164

(ii) The main advantage is that shareholders will have a better idea of the value of
the property that their company controls. That should give a more realistic
insight into the resources used by the company in order to generate income. A
value might also enable the shareholders to make sensible decisions about,
say, whether the property should be retained or sold.

The biggest disadvantage of a valuation is that it will be subjective and will be

open to manipulation. There may be professional fees associated with

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2009 — Examiners’ Report

determining the value. Another disadvantage is that it reduces the return on

capital employed.

(iii) There are many transactions that might affect the bank balance but have no
impact on profit, for example, the repayment of a loan. This appears to have
happened part of the way through the year because the company has a very
high interest charge relative to the amount borrowed at the year end.

Profit does not always generate cash immediately. Credit sales will be
recognised before any cash is generated. Companies can even run into a
problem called “overtrading” when they are growing and start to put a strain
on their working capital.

Part (i) of this question was really well answered by candidates with many candidates
scoring full marks. There were some variations in where to show some items but generally
the attempts at this were very good. It is excellent that so many candidates can prepare
accounts so well.

Part (ii) This part was done reasonably well with many candidates scoring a high mark.
Most candidates mentioned subjectivity and the fact that 2 valuers may give different
valuation for the same property.

Part (iii) Most candidates scored a reasonable mark for this part of the question. Well done!

20 (i) Present cost of equity = 4% + (1.6 × 6%) = 13.6%

Estimated ungeared beta, with investment

= (1.6 × 60/80) + (1.1 × 20/80) = 1.475

Working: Debt/equity ratio = 20/60 = 0.333

Estimated geared beta, with investment = 1.475 × (1 + (0.333 × (1 – 0.28))

= 1.829

Working: cost of equity, with investment = 4%+ (1.829 × 6%) = 14.974%

cost of debt = 8% × (1 – 0.28) = 5.76%

Weighted average cost of capital = (14.974 × 60/80) + (5.76% × 20/80)

= 12.670%

(ii) Arguably, each project should be evaluated in terms of its own individual risk.
That means that the cost of capital is only an appropriate rate if the investment
constitutes an overall expansion of the business. Even then, it is debatable
whether the markets will view the expansion as having the same risk as the
company as a whole. The existing cost of capital is, at best, a rough
approximation to an appropriate discount rate.

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2009 — Examiners’ Report

The managers could, in fact, use the project’s beta coefficient to calculate the
relevant discount rate. With a beta of 1.1, the project should be discounted at
4% + (1.1 × 6%) = 10.6%.

(iii) The directors are mistaken because the project should really be evaluated in
terms of its impact on shareholder wealth. The shareholders should have
diversified portfolios already, so the additional diversification from this
project should not really do them any good. The project has a lower beta than
the company as a whole, so the project will reduce the shareholder’s weighted
average beta and reduce their overall risk profile. That is not necessarily a
good thing because the shareholders may prefer a slightly higher risk in order
to generate a slightly higher expected return.

Arguably, the directors will be the only real beneficiaries of the diversification
effect. The fact that most directors will derive most of their income from that
one company and that they have their career tied up in it will make them more
exposed to any risks.

Part (i) Generally candidates did well in this part of the question. Most candidates were
familiar with the calculations required. Unfortunately there were some candidates who
scored zero for this part and they must revise this topic for the future.

Part (ii) This part was done very poorly with many candidates scoring zero marks. Again
some revision of this topic is required before the next attempt.

Part (iii) This part of the question was also done very badly. Candidates showed very little
understanding of the topic of risk. Candidates did mention diversifying portfolios but not in
enough depth to get a high mark. Although candidates can do the calculations for this topic
they seem to lack understanding of the topic and do not know what the calculations show.
This is very important and should be revised.

This whole topic requires some revision.

END OF EXAMINERS’ REPORT

Page 10
Faculty of Actuaries Institute of Actuaries

Subject CT2 — Finance and Financial Reporting

Core Technical

EXAMINERS’ REPORT

September 2008

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

November 2008

Comments

It was good to see some better results than in the previous diet.
There were some excellent papers.
As discussed above there are some areas where there could be an improvement and some
areas where revision would be sensible.
On the whole a much better performance than last time.

Comments on individual questions are given after each of the solutions that follow.

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2008 — Examiners’ Report

1 C
2 A
3 C
4 C
5 B
6 A
7 A
8 D
9 D
10 B

Q1–10 comments: The MCQs were done well by most candidates. There was no noticeable
problem with any question. Well done!

11 The output of a simulation will offer the directors an indication of the distribution of
expected outcomes from the project . That will also indicate the project’s sensitivity to
different factors and assumptions . The output from the simulation might reduce the
need to establish a hurdle rate in advance . Simulation may make it possible to
evaluate projects that could not otherwise be analysed analytically.

The reliability of the simulation depends on the reliability of the underlying

assumptions . If the model is specified badly then the resulting projections will be
incorrect . There is a danger that a sophisticated analysis will have more credibility
than it deserves and the directors will have undue confidence in the results .

Q11 comments: The majority of candidates could identify roughly what a simulation
was, scoring marks for a distribution of outcomes and use to test sensitivity. A
noticeable number discussed scenario testing, sensitivity analysis and monte carlo
analysis separately rather than focusing on simulation but still showed enough
understanding for two marks. Only a minority really discussed the
drawbacks/difficulties of using it. Drawbacks were generally limited to use of an
expert, cost and time constraints rather than difficulties with the input variables or
over confidence in the results.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2008 — Examiners’ Report

12 The main reason for being in business is to generate profit . A healthy profit is vital to
a company’s long-term viability . In the short term it is possible that investment and
expansion will lead to an outflow of cash. Such outflows are not dangerous in
themselves provided they are properly managed. If the company is profitable then it
will generate net cash in the very long term. That means that it should be possible to
borrow in order to deal with short-term cash crises. However, profitable companies
can collapse if they are short of cash, so the situation should be monitored.

Cash flows are important to the short-term survival of the business, but they are not
long term business objectives. A cash outflow might occur because of a deliberate
decision to put surplus funds to work in the business.

Q12 comments: Generally high marks were scored. Most started with a discussion on
accruals and realisation concepts and how cash is different to profit but went on to
discuss plausible reasons that do not cause concern and discussed the pitfalls of
running out of cash. The weaker candidates tended to list possible causes of a
difference (e.g. purchase of assets — high cash outflow now but depreciation reduces
profit over many years) without really explaining whether it was a cause for concern
i.e. did not answer the question.

There were some excellent answers for this question. Well done!

13 Ratios provide insights into the policies and strategies followed by the company. An
understanding of the business is necessary in order to make an informed decision as to
the merits of a strategy or policy. For example, a company might have a very high
gross profit percentage because it sells a premium brand. It might look as if the
company is losing sales volume because of its pricing policy, but the company may
know that its exclusivity and pricing is one of the factors that actually attracts
business.

Some businesses are forced to accept certain costs and inefficiencies because of
industry norms. For example, slow payment might be the norm in a particular
industry. It would be dangerous to press for a reduction in a debtors’ turnover ratio if
that would mean offering less attractive credit terms than the rest of the industry.

Q13 comments: It was heartening to see that this question was answered well by
many candidates. Generally good examples were provided.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2008 — Examiners’ Report

14 A qualified audit report indicates that the auditor had a specific concern or concerns
with the financial statements. This could arise because of material disagreement over
the figures and the manner of their calculation or certain types of uncertainty
concerning the audit, such as a limit on the information obtained.

Anyone reading a qualified audit report should be alerted to the auditor’s particular
concerns. The information in the audit report should be specific enough for the reader
to have a clear idea of the potential problems with the accounts. The reader might
reinterpret or restate the figures in response to any disagreement or might attach less
confidence to them because of any uncertainty.

Q14 comments: The majority of candidates identified what a qualified audit report
was and that there would be a lack of confidence (sale of shares was a common
answer). However, generally the answers went into as much detail on the other forms
of report. Many candidates discussed unqualified reports, this was not required, nor
was a discussion on types of qualification.

15 Stock options give the directors an incentive to work on improving the company’s
share price. The options will only have value if the share price exceeds the strike price
when the options reach their maturity. This should have the effect of reducing many
of the agency concerns that the shareholders might perceive. Maximising shareholder
wealth should have the effect of enhancing the value of the stock options.

If a significant number of options is issued in this way then the shareholders risk the
dilution of their equity when they are exercised. This could make the options a very
expensive form of remuneration.

Q15 comments: Most candidates did this question very well and scored high marks.
Well done!

16 The government may seek to encourage private and institutional pension

arrangements by offering tax relief (or even subsidy) on contributions and, possibly,
investment earnings within the pension scheme. The tax relief will make it
particularly attractive for individuals on higher rates of tax to invest in a pension plan.
The relief offered to the schemes themselves makes it easier to build up a solid asset
base with a view to making it possible to provide better pensions in the longer term.

While the final pension benefit will be subject to tax, when paid, the individual
recipient will often benefit from a lower personal tax regime when in retirement. This
prospect makes it very tax-efficient to put off taking income during employment and
putting as much as can be afforded into a pension.

Q16 comments: Answers varied widely. Surprisingly a large number limited their
answers to tax relief on contributions and ISAs. A noticeable number took a
theoretical standpoint and discussed possible measures the government could take
e.g. increasing taxes on expenditure. This question was answered badly by many
candidates.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2008 — Examiners’ Report

17 In theory, the switch to a company will protect the personal assets of the partners.
Any claims made against them will be limited to the assets of the company itself. In
practice, that might not always work because lenders might insist that the
directors/shareholders of a small company give a personal guarantee against the
company’s assets.

It might be easier to expand in the future because the company structure will make it
easier to admit an additional owner. The new partner would have been jointly and
severally liable for the partnership’s liabilities, but would not be liable for anything as
a member of the company unless s/he signed a guarantee.

The creation of a company will also give other parties dealing with it a clearer idea of
whom they are involved with. For example, a new employee will work for the
company, which has a separate legal identity, rather than a collection of partners.

Q17 comments: This question was generally answered well but often candidates
wasted time discussing disadvantages of Ltd companies or advantages of
partnerships. Apart from that this was well answered.

18 Discretionary monitoring costs and covenanting costs could only be eliminated if the
stakeholders could trust one another. In principle, this would simply require mutual
confidence in one another’s integrity. In practice, there would always be observable
conflicts of interest and that would create room for doubt. These doubts would grow
because of information asymmetries. Concerns about attitudes and commitment
would grow because those whose behaviour and intentions were in doubt would be
the source of any assurances offered.

In reality, it can be seen that these pressures often lead to additional, non statutory
monitoring and disclosure that is designed to reduce the uncertainties arising from
information asymmetry.

Q18 comments: Candidates tended to provide examples of how different stakeholders

had differing interests in the business and their requirements and goals varied as a
result which would cause mistrust and conflict. This was an equally valid approach.
On the whole this question was answered well.

19 (i) Returns from financial investments are set by market forces. The market
rewards investors for delaying consumption and for bearing risks. Market
prices rise as risk falls, thereby correcting any excessive return for a given
level of risk. This investor is bearing relatively little risk and so his returns are
unlikely to be high. The market would offer a better return if he wished to bear
greater risk through investing in a more volatile set of securities.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2008 — Examiners’ Report

In a CAPM world, the markets restrict the return for risk to systematic risks
only. Our investor has built a portfolio with a relatively low systematic risk.

Q19 (i) comments: The majority of candidates provided CAPM equations and
explained these and generally candidates explained low risk = low return.
This question was done well by the majority of candidates.

(ii) A portfolio of low beta shares will have a relatively low volatility relative to
the market as a whole. If the average beta is 1.0 then the portfolio should
move in line with the market as a whole. If it is less than 1.0 then market
fluctuations will still work through, but they will be lower than the volatility in
the market. The investor will still bear some systematic risk.

Diversification cannot ever eliminate every risk that adversely affects all
securities to some extent. The tsunami is an example of such an event because
it affected economies and costs (e.g. of insurance coverage) and so the markets
as a whole experienced a downturn.

Our investor’s diversification is also likely to be imperfect. Dealing costs

mean that investors have to spread their capital across a restricted number of
shares, and each will be over-represented relative to the market as a whole.
Thus, a diversified investor may still have too much invested in travel
companies and be unduly affected by a disaster that affects that industry.

Q19 (ii) comments: This part of the question was done badly by many
candidates. Most candidates were struggling to give more than a brief
answer. The majority of answers were limited to mentioning that the tsunami
was a systematic risk that could not be diversified away. Marks were fairly
poor for this section.

(iii) A beta of zero means that an investment will not be affected by a movement in
the market. That means that, in theory, the investment is risk free. However,
that is only true in the context of a diversified portfolio. Our investor will have
full exposure to all of the specific risks associated with this development.

If the project has an attractive forecast return then it is reasonable to expect the
associated risks to be equally high. Otherwise, there would be so much
competition to buy property on the development that supply and demand
would push prices up and potential returns down.

Our investor appears to have a low appetite for risk. This is a risky investment
and so probably will not appeal. Investments in overseas properties can be
particularly dangerous because of misunderstandings about legal rights and
obligations and because of the danger of oversupply in certain markets.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2008 — Examiners’ Report

The property development would also cost our investor all of the liquidity that
he presently enjoys. Quoted shares can be bought and sold freely, but a
property investment requires capital to be tied up in the long term and it can be
difficult to release equity.

Q19 (iii) comments: There were some good answers which provided a solid
explanation and provided examples of specific risks the investor would be
exposed to. However, too many candidates saw the low beta and decided that
the risk was low and the returns high so it was a good idea. This topic should
be revised in depth by future candidates it comes up again and again and is
never well answered.

20 (i)
Extra depreciation
£10m × 10% = £1.0m

Extra interest
£10m × 9% × 2/12 = £150,000

Grow Ltd
Forecast income statement
for the year ended 31 December 2008
£000
Revenue 5,000
Cost of sales (3,000)
2,000
Other operating costs (500)
1,500
Finance charges (870)
Net profit 630

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2008 — Examiners’ Report

Grow Ltd
Forecast balance sheet
as at 31 December 2008
£000 £000
Non-current assets 26,500

Current assets
Inventory 167
Trade receivables 417
Bank 50
634
Total assets 27,134

Equity
Share capital 5,000
Retained earnings 3,720
8,720
Non-current
liabilities
Loans 18,000

Current liabilities 414

27,134

Q20 (i) comments: Errors were in the calculations rather than the placement
of the adjustments e.g. interest may have been miscalculated but the incorrect
figured was carried forward correctly and adjusted in the I/S and the B/S.
Therefore candidates tended to score high marks. The main error was
miscalculation of the interest and failing to adjust the current liabilities.

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Subject CT2 (Finance and Financial Reporting Core Technical) — September 2008 — Examiners’ Report

(ii) (a)
Without asset With asset

ROCE 2,500/(9,870 + 8,000) 1,500/(8,720 + 18,000)

= 14% = 6%

Gearing 8,000/(9,870 + 8,000) 18,000/(8,720 + 18,000)

= 45% = 67%

(b) The investment will make the company appear far less profitable (due
to the lower ROCE) and far more risky (because of the much higher
gearing ratio). Thus, the investment might undermine shareholder
confidence.

Q20 (ii) comments: Generally well answered.

(iii) Shareholder wealth is a function of future cash flows. Future cash flows are
not affected by accounting choices or the accounting treatment of transactions.
Entering into a transaction that has an adverse impact on the financial
statements in the short term should not affect the long term prosperity of the
company. The directors should be able to explain the short-term distortions
arising from investments and other events.

Unfortunately, in the real world shareholders will not always accept

explanations of temporary downturns. Companies usually claim that bad
results should not be taken too seriously because they do not wish
shareholders to panic, so explanations and reassurances often carry very little
weight. Shareholders may well pay more attention to a concrete set of reported
results that have been audited than to a statement that the company is pursuing
long-term goals.

The directors might feel that their personal positions are threatened by the
effects of the transaction on the income statement and balance sheet. If the
share price is depressed by concerns about the figures then the company could
be taken over and the directors replaced.

Q20 (iii) comments: There were many good answers here. Some weaker
candidates misunderstood the question and discussed the ethics behind
accounts manipulation, or deduced that as gearing had gone up and ROCE
down the project was less profitable and was not worthwhile. On the whole
this was done reasonably well.

END OF EXAMINERS’ REPORT

Page 9
Faculty of Actuaries Institute of Actuaries

Subject CT2 — Finance and Financial Reporting

Core Technical

EXAMINERS’ REPORT

April 2008

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

June 2008

Comments

There were some excellent marks achieved on this paper; well done to all those candidates
who scored high marks. It was however disappointing that the pass rate was poor compared
to the last diet. There were also some very poor scripts at the bottom of the spectrum.

Candidates generally achieve high marks in the questions where knowledge is the main
requirement; it is however disappointing to note that where application of knowledge is
required there are some very poor answers.

As usual, in this exam, it is the two long questions at the end where some candidates get very
low marks.

It is very beneficial to practise past exam questions and I would recommend that all
candidates try to complete past papers within the time constraints required when revising.

Comments on individual questions are given after each of the solutions that follow.

© Faculty of Actuaries
© Institute of Actuaries
Subject CT2 (Finance and Financial Reporting Core Technical) — April 2008 — Examiners’ Report

1 A
2 D
3 B
4 D
5 A
6 C
7 B
8 D
9 C
10 A

Comments: Generally Q1–10 were done very well. Many candidates scored full marks.
This was gratifying, as the marks for the MCQs were fairly poor for the previous two diets.

11 Advantages:
The balance sheet will better reflect the underlying worth of the company’s assets .
This will enable shareholders to have a better appreciation of management’s
stewardship (because there is a more realistic measure of the value of the assets
entrusted to them) . Lenders will have a better understanding of the value of assets
being pledged as collateral. It fits in with more recent emphasis on ‘fair value’.
Disadvantages:
Valuations will always be more subjective than stating figures at cost less
depreciation. There will be costs, such as valuers’ fees, associated with showing
valuations. Values are likely to be more volatile than cost less depreciation and the
associated fluctuations might make the business appear more risky.

Comments: This question was done very well by most candidates. It was good to see
such good answers to this question.

12 The notes provide additional detail concerning the underlying figures. These analyses
will provide the shareholders with a better understanding.
Notes might deal with qualitative matters and disclosures that could not be reflected
in the financial statements. For example, descriptions of contingent liabilities could be
vitally important.
Many of the disclosures in the notes are required by law. The rules and regulations
associated with accounting effectively require the publication of notes to the accounts.
Providing an overview in the main statements and supplementing that with the notes
gives shareholders and other readers the choice of reading further if they wish. Expert
readers can consult the notes while non-experts can stick to the statements
themselves.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — April 2008 — Marking Schedule

Notes and appendices avoid burdening the income statement and balance sheet with
excessive information.

Comments: This question was done well by many candidates. Few candidates
mentioned that many of the notes are statutory requirements or that qualitative
matters could be discussed by note and this would be very informative for users of
financial statements.
On the whole there were some very good answers for this question which was good to
see.

13 Accounting standards provide a basis for consistent treatment between companies.

They are the accountancy profession’s response to inconsistent treatment or to
accounting practices that are controversial or potentially misleading.
Accounting standards provide companies with a benchmark against which to measure
the validity of their accounting policies and to demonstrate that their accounts give a
“true and fair” view. That may reduce agency costs due to shareholders and other
readers being concerned that the accounting policies in force are incorrect. The fact
that financial statements are supported in this way should enhance shareholder
confidence in the resulting figures and so the share price should be higher.
The publication of accounting standards also enhances the accountancy profession’s
reputation. The resources invested in the process provide proof that the profession is
taking its responsibilities seriously and provide a mechanism for debating important
issues.

Comments: There were a few very good answers to this question but on the whole it
was poorer than expected. The answers were very short and lacked any detail.

14 Further loans might rank alongside or even ahead of the existing lender’s rights in the
event of liquidation. Barring the borrower from taking out further loans will reduce
the risk of assets being diluted in the event of a foreclosure or claim. The payment of
additional interest will have an impact on cash flows.
The additional debt might increase the risk of the company failing. Even if that does
not directly threaten the existing lender’s rights, the lender would rather have its
customers survive and repay their debts on time.
If the company cannot raise fresh funds from borrowing then it will have to raise
equity. Equity provides a “buffer” between the value of assets and liabilities and the
higher the equity the safer all lenders’ positions become.

Comments: This question was done reasonably well. Most candidates mentioned the
possibility of the company failing and of raising capital by equity rather than debt if
they could not raise a loan.

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2008 — Examiners’ Report

15 Opportunity cost is the cost of passing up the next best choice when making a
decision. If a company has mutually exclusive projects then the opportunity cost of
accepting one project is that it will be impossible to accept any of the others. For
example, building a bridge with an NPV of £1m might mean that there is no real point
in building a tunnel which would have an NPV of £1.5m if built on its own.
Companies might also face capital rationing. Accepting a positive NPV project might
involve using funds that could be applied more profitably elsewhere.
Considering opportunity costs complicates the investment appraisal process because
of the need to determine the NPV of competing projects. However, it may be difficult
to spot opportunities that have been missed or overlooked and so there may be very
little risk of criticism arising from a missed opportunity.

Comments: This was a fairly standard question and was done well by most
candidates.

16 Rights issues are less complicated than making an issue to members of the public.
There are fewer regulatory requirements to be dealt with and the company can
therefore pay less in fees and other costs. There may be less need to underwrite the
issue. This may make rights issues more cost-effective for dealing with smaller
amounts of equity.
Rights issues simplify the issues associated with setting prices. Any discount will be
enjoyed by existing shareholders. This will avoid diluting the equity of existing
shareholders if the shares are issued at a discount.

Comments: This type of question has been asked many times in previous diets, it was
therefore very disappointing to see so many poor answers. While many candidates
could mention the basic points few achieved a high mark.

17 The basic earnings per share reflects both the earnings for the most recent year and
the number of shares with a right to participate in those earnings. Ultimately, the
shares only have value because earnings create the potential for the company to pay
dividends and generate cash for the shareholders.

The diluted earnings per share adjusts for the potential effects of converting or
exercising any instruments in issue that give their holders the right to obtain ordinary
shares. If there is a large quantity of such instruments in issue then there is the
potential for a major dilution of the earnings enjoyed by existing shareholders.
Conversion will normally involve an inflow of cash, and eliminate some other
outgoings, such as interest on a convertible bond, but the gains from doing so are
unlikely to fully compensate for the larger number of shares in issue. Apart from
anything else, the rights associated with such instruments have to be attractive to
buyers or they will have to be offered at a lower price.

Comments: This question was not very well done. Some candidates wrote very short
answers for this. Many candidates were unsure what diluted earnings per share
meant and gave poor answers to this. This is an area of the syllabus that candidates
should revise for the next attempt.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — April 2008 — Marking Schedule

18 (a) A subsidiary is a company that falls under the control of a holding company.
This normally happens through ownership of a majority of shares carrying
voting rights, but there is no need to own any shares in order to create this
relationship.

(b) Consolidated financial statements are necessary in order to show the holding
company shareholders how their wealth is being invested. The group is an
economic entity. The financial statements of the individual companies give no
real insight into the performance of the group as a whole.

A consolidated balance sheet is required to avoid the group from misreporting

the resources available to the directors and the associated liabilities that have
been used to finance their acquisition. Internal relationships need to be
identified and cancelled.

Comments: This question was answered well by many candidates. Part (a) was well
done but part (b) less so. Again some revision of this area of the syllabus would be
useful before the next attempt. This question was straightforward and very high marks
should have been achieved by candidates.

19 (i) Generally, shareholders who have significant taxed income from other sources
prefer that companies do not pay dividends. This is because the additional
income from the dividend will be taxed at the taxpayer’s highest rate.

In theory, if a company reinvests profits rather than paying them out in

dividends then the value of shares should increase, and the shareholders will
then receive a capital gain equivalent to the dividend that has been foregone.
Thus, pre-tax, shareholders are indifferent between dividends and capital gains
However, the tax treatment of capital gains is different for a number of
reasons. Firstly, the taxpayer will probably have a separate annual allowance
for capital gains. Secondly, the marginal rate of tax paid on capital gains may
be lower than that on income. Thirdly, the tax payable on capital gains can be
deferred by retaining the shares and selling only when it is deemed
advantageous to do so. Tax on income has to be paid almost immediately, with
no real opportunity to manage this.

Companies that have known and predictable dividend policies are likely to
attract shareholders with a particular preference for income versus capital
gains. If the company switches from one approach to the other without giving
substantial warning then shareholders could be disadvantaged.

(ii) The basic accounting equation is Assets = Capital + Liabilities. Every asset
has to be financed by either equity or borrowing and every source of finance
carries a cost. Holding assets that do not yield any return means that the
company is incurring a cost of capital for nothing .

The shareholders will view a “wait and see” policy as a low return on their
equity. The directors have a responsibility to maximise the owners’ wealth. If
they cannot offer a realistic return on cash holdings then they should give the

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2008 — Examiners’ Report

funds back to the shareholders. To do otherwise imposes an opportunity cost

in terms of delaying consumption or in terms of leaving shareholders unable to
invest elsewhere to greater effect.

There are also market forces at work . A substantial cash balance would make
the company attractive to a predator. The directors’ apparent inefficiency
would make such a bid more attractive. These disciplinary forces are one of
the most powerful motivators to ensure that the directors focus on the
company’s profitability.

(iii) The directors face a dilemma when deciding what information to release.
Competitors will use anything that they release to gain an advantage.
However, withholding information will create uncertainty in the minds of
shareholders (the agency costs of information asymmetry). That uncertainty
will translate into a reluctance to trust the directors and so share prices will fall
and loan agreements will become more difficult to complete. That will push
up the cost of capital.

In theory, keeping the markets informed should protect the company from
some of the disciplinary forces that might threaten the directors’ positions.

Comments: This question was generally done badly. Part (i) was poor; although
candidates could mention how capital gains were taxed that was really all that was
said. It was disappointing that few candidates mentioned anything about the
advantages of companies with a steady dividend policy.
Part (ii) was also very poor with many candidates giving very short answers. Very
few candidates seemed to understand that holding assets that do not create any return
was a poor idea.
Part (iii) was also poor. A number of candidates did not answer this at all and others
gave very short answers along the lines of “information is important”. This was not
rewarded. It was disappointing that few candidates had thought about this issue.
Some revision of this topic would be useful before the next attempt.

20 (i) Proceeds of winding up:

Intangible assets 0
Property, plant and equipment 6.0m
Current assets 2.5m
8.5m
Applied:
Secured loans 7.0m
Unsecured lenders 1.5m

Thus, unsecured lenders will share £1.5m in settlement of their £3m liabilities,
so they will receive 50% of the amount due. Vest will received £250,000 .

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2008 — Marking Schedule

(ii) (a) Initial outflow = £8.5m

Inflow = £0.8m in perpetuity.
At 8% this has a net present value of £0.8m/0.08 - £8.5m = £1.5m
At 11% this has a net present value of £0.8m/0.11 - £8.5m = (£1.2m)

(b) The desirability of this project depends on the discount rate that is to
be applied. Thus, it is not entirely clear cut whether it would be a good
investment.

(iii) (a) The required rate of return should be related to the risks associated
with the project itself. The proposal is going to take Vest into
completely new territory because it does not manufacture this range of
products. Thus Vest’s normal required rate of return is not appropriate.
The strategic fit of the proposal also has to be considered . There might
be synergies or inefficiencies associated with working in this way and
so the cash flows from the project ought to be looked at in conjunction
with those of Vest.

Vest’s shareholders will not necessarily share their directors’

impression of the investment. The investment could have a knock-on
effect on Vest’s share price and its overall cost of capital.

Rough’s required rate would not be appropriate, partly because the

company will be reorganised and be manufacturing a different product
and partly because the company’s collapse gives additional insights
into its risks.

(b) Ideally, Vest will be able to identify an appropriate rate by finding a

quoted company whose business is similar to that of the reorganised
Rough. That company’s cost of equity would be an ideal basis for
setting the required rate of return .

Alternatively, Vest might be able to obtain a beta coefficient for a

similar investment, thereby determining the systematic risk of the
project and setting an appropriate required rate of return.

Vest might attempt a simulation exercise for the company. Designing a

model that estimates cash flows under different situations and inputting
a range of assumptions would give some idea of the extent to which
the company is exposed to different risks. The resulting output would
give an indication of the expected distribution of outcomes that might
be expected and so the value might be more easily determined.

Comments: This was a fairly standard question and it was answered very badly.
This type of question has been asked in the past so it should not have come as a
surprise.
Part (ii) was done reasonably well but part (i) was very poor. It was very
disappointing to see many candidates doing (i) so badly. It would be an excellent idea
to look closely at past exam papers and attempt them under exam conditions before
the next attempt.

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2008 — Examiners’ Report

In (iii) (a) very few candidates mentioned the possible effect on the cost of capital or
the share price. This point demonstrated understanding and was an excellent point to
make but very few candidates mentioned this.

END OF EXAMINERS’ REPORT

Page 8
Faculty of Actuaries Institute of Actuaries

EXAMINATION

September 2007

Subject CT2 — Finance and Financial Reporting

Core Technical

EXAMINERS’ REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

December 2007

Comments

Comments are given after each of the solutions that follow.

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2007 — Examiners’ Report

1 D
2 B
3 C
4 B
5 B
6 B
7 D
8 A
9 C
10 B

Questions 1–10 were generally done well by most candidates.

11 Specific risk is the risk that is directly related to the investment itself . For example,
the company might have to recall a product and incur substantial costs as a result.
Systematic risks are those that are shared to a greater or lesser extent by all
companies. For example, global economic cycles means that all companies are subject
to occasional slumps. Investors need not be concerned with specific risk because
those risks can be cancelled through diversification. Provided the investors have a
diversified portfolio, their risk is related to the systematic risks of the individual
investments.

This question was done very well by most candidates.

12 There is no guarantee that the necessary surpluses will be generated in time to meet
the company’s needs. This could interfere with the efficient implementation of the
investment programme. A series of losses could even restrict the very expansion that
is necessary to return the company to profit.

The use of retained profits could interfere with the company’s ability to pay
dividends. Shareholders tend to have particular preferences for either dividends or
capital gains. Suspending a dividend to fund growth could lead to the sale of shares
and the reduction of the share price.

Retained earnings have the same cost as ordinary shares. That makes this an
expensive form of finance in comparison with debt.

It was really good to see so many excellent answers to this question. Well done!

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2007 — Examiners’ Report

13 The figures in the balance sheet can be a combination of historical £ amounts from
different dates when the purchasing powers were all different. The total might not be
particularly meaningful if the assets are relatively old.

The figures in the income statement relate current selling prices to historical costs of
inventory and depreciation. This can have the effect of overstating profits when prices
are rising.

The historical cost of an asset is unlikely to be directly relevant to any decision, unless
it happens to be a reasonable approximation for another value. For example, it is
useful to know how much a piece of inventory would cost to replace before deciding a
selling price. Its historical cost might give a rough approximation, but not necessarily

This question was also answered well. However some candidates went on to discuss
depreciation methods in detail which was not required.

2m
(2m × 3.00) + ( × 2.40)
14 Price after issue = 5 = £2.90
2m
2m +
5

The actual price will depend on the market’s expectations concerning the use to which
the investment will be put. If the market feels that the directors have been unduly
optimistic then the theoretical price might not be realised. The theoretical price also
does not take into account the associated costs of the issue

This question was extremely well done by most candidates.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2007 — Examiners’ Report

15 Warrants are financial instruments that give the holder the right to buy additional
shares at a fixed price by some future date. The holder of a warrant can participate in
any subsequent growth in the share price, particularly if the warrant has a long lead
time and gives the company the opportunity to raise further funds and grow over time.

The terms of the warrant can give additional shares to the original buyer (or even be
restricted to shareholders who hold their original share allocations). That gives
shareholders an incentive to stay with the company.

Warrants can be a relatively inexpensive means of offering an incentive to potential

investors, particularly in the case of an established business that is trying to raise fresh
finance without giving up too much control.

The main problem with warrants is that they can lead to the dilution of shareholders’
rights if they are exercised in the future. That might deter some shareholders from
investing in the company once it is well established. Certainly the threat of dilution
will reduce the price at which new shares can be issued .

This question was answered reasonably by many candidates but very poorly by others. Some
revision of this topic is required.

16 Admitting a partner may require the introduction of further long-term finance into the
business. That could either fund expansion or give the owner the opportunity to
realise some of his investment

A partner will have an incentive to make the business a success. A new employee
could be just as talented, but will have less to gain from the success of the business .

The owner will have to surrender outright control of the business to give the partner
some say in its management.

The owner will be jointly and severally liable for the liabilities of the partnership.
Anything that the new partner commits the partnership to will be the personal
responsibility of both partners

This question was answered extremely well by many candidates.

17 Stock markets exist to process information as effectively and with as little bias as
possible. Share prices must reflect the market’s expectations of future cash flows or
the shares will be mispriced and investors who realise that will be able to buy or sell
at advantageous prices. This creates a situation where the directors must work towards
running things so that they create as much wealth as possible on behalf of their
shareholders. If they do not then the share price will fall and that could lead to them
being threatened with a takeover bid. In that case the directors may be replaced by a
new board appointed by the victors.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2007 — Examiners’ Report

Markets also operate in the provision of debt. A great deal of effort goes into forming
an opinion on corporate credit ratings. Companies which have poor ratings will have
to pay more for their debt, with consequences for profit and share price .

This question was answered very well.

18 Firstly, income from certain investments such as Personal Equity Plans (PEPs) or
Individual Savings Accounts (ISAs) is tax free .

Dividends from companies are effectively paid net of basic rate tax. This is not
immediately obvious from an individual’s tax return because the gross income has to
be declared, but the resulting tax is offset by the deduction. This “tax credit” is
designed to compensate for the fact that the company has paid corporation tax on the
profits from which the dividend is paid. It could, however, be insufficient to cover any
additional tax due because the taxpayer is subject to higher rates of income tax .

The taxpayer would have received some tax relief on the contributions paid into the
pension scheme. That means that the subsequent taxation of benefits paid is actually
the first time that the taxpayer has been taxed on that .

This question was done well by most candidates.

19 (i) The expected gain is higher from the branch for the feasibility study because
the probability tree makes it clear that the project should be abandoned if the
feasibility study suggests failure. This suggests that the additional information
about the risks associated with proceeding outweigh the cost of the study. If
the company would carry on with the investment even if the feasibility study
indicated otherwise then it would be better not to conduct it because that
would be a waste of money, unless the study was likely to yield information
that would somehow enhance the probability of the project’s success.

(ii) Probability trees are useful for resolving projects which involve sequential
decisions where the outcome can be changed once the project is under way.
This enables the decision maker to allow for different contingencies at the
planning stage. For example, in this example the company must decide
whether or not to conduct a feasibility study. Once the study has been
undertaken the company must decide whether to proceed with the expansion .
Probability trees are best suited to circumstances where probabilities can be
estimated for different eventualities. This means that the method is best suited
to relatively simple chains of decisions.

(iii) A simulation exercise can be much richer than a probability tree. It is possible
to incorporate far more variables into a simulation than to a probability tree. It
may also be possible to deal with distributions that might not be open to an
analytical solution. The simulation could allow for far more complex
probability distribution functions. It would also be possible to have more
realistic ranges of outcomes than the present “success” or “failure” dichotomy.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2007 — Examiners’ Report

A simulation will also provide an insight into the range of possible outcome
from different choices. The results can be presented as a distribution of
outcomes from each major choice open to the directors .

(iv) The project must be capable of being modelled. For example, it would have to
be possible to model the likelihood of the company recruiting suitable local
employees. The effects of each possibility will also have to be built into the
model so that, for example, the effects of the jobs market variables are
consistent with the salary variables. This might involve assuming that
managers behave rationally, but in practice human decision makers might not
take the most appropriate decisions when faced with, say, a run of bad luck .

(v) All of the decision tools for appraising capital projects require highly
subjective decisions and estimates from the decision makers. The results of the
appraisal exercise can be predetermined by biasing assumptions. Furthermore,
some decision aids have an inbuilt bias of their own (e.g. payback favours
early cash flows). This means that the choice of decision model can be just as
important as the decisions. It may not be a bad thing that these factors exist.
Arguably an instinctive assessment of a project’s viability can be as valid as a
slightly distorted impression from a supposedly objective model.

This question was answered poorly by many candidates. Most just wrote everything they
knew about simulations and probability trees.

The marks for this question were very poor compared to the rest of the paper. Some revision
of this topic is required by many candidates.

The main problem was that candidates simply did not answer the question.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2007 — Examiners’ Report

20 (i)
CKL plc
Income statement
for the year ended 31 August 2007
£000 £000
Sales 4,400
Cost of sales (2,535)
Gross profit 1,865
Administration (390)
Distribution (510)
(900)
Operating profit 965
Investment income 40
Interest (18)
Net profit before tax 22
987
Tax (50)
Net profit after tax 937

CKL plc
Statement of changes in equity
for the year ended 31 August 2007
Retained
profit
£000
Opening balance 748
Net profit for year 937
Dividend (300)
Closing balance 1,385

CKL plc
Balance Sheet as at 31 August 2007
£000 £000
Non-current Assets
Tangible 2,555
Investments 900
3,455
Current Assets
Inventory 420
Trade receivables 258
Bank 16
694
4,149

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2007 — Examiners’ Report

EQUITY AND LIABILITIES

Equity
Share capital 1,800
Retained earnings 1,385
3,185

Long term loans 800

Current liabilities
Trade payables 114
Tax payable 50
164
4,149

Formats

Non-current assets
Cost Aggregate Net book
depreciation value
£000 £000 £000
Premises 2,400 77 2,323
Machinery 500 268 232
2,900 345 2,555

Workings

Cost of sales
Materials 1,420
Repairs 190
Wages 800
Depreciation on premises 48
Depreciation on machinery 77
2,535

Admin
Directors salaries 170
Wages 220
390
Distribution
Advertising 400
Wages 110
510

(ii) A fixed asset is something that will be held by the business and will be used to
generate income over more than one period. Any expenditure on a fixed asset
that increases its capacity to generate income should be classified as an
addition to fixed assets. For example, an extension or a modification to a
production line should be treated as a fixed asset. Repairs are essentially

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2007 — Examiners’ Report

running costs of the business. A repair would have the effect of ensuring that
an asset would continue to run and generate an income. For example, the
routine servicing and lubrication of a machine would be a repair.

On the whole the first part of the question was well answered, the only really common error
was confusing the stock in the Income Statement and therefore getting an incorrect Cost of
sales figure. Some compounded this error by changing the Balance Sheet to make it balance
which then made an additional figure incorrect. The formats were generally poor. Many
students omitted part b or gave a very brief answer – few scored highly here.

END OF EXAMINERS’ REPORT

Page 9
Faculty of Actuaries Institute of Actuaries

EXAMINATION
April 2007

Subject CT2 — Finance and Financial Reporting

Core Technical

EXAMINERS’ REPORT
Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

June 2007

Comments

Generally the standard of answers was poorer than usual. Candidates did not appear to be
well prepared for this exam. The standard of questions was similar to previous diets,
however the answers were of a lower standard. The depth of many answers was poor. There
were, as usual, some very good papers which is always heartening.

Further comments, where appropriate, are given in the solutions that follow.

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT2 (Finance and Financial Reporting Core Technical) — April 2007 — Examiners’ Report

1 A
2 C
3 B
4 B
5 D
6 B
7 C
8 C
9 A
10 C

Q1–10 were not answered as well as usual. Very few candidates achieved full marks. There
was no one question that was poor. There were some extremely poor marks which is
unusual.

Candidates need to be well prepared to sit the exam, more revision is required before the
next sitting in September.

11 Stakeholders have conflicting interests due to the commercial realities of the business.
For example, corporate social responsibility is good for the public but may be costly
to the shareholders. Therefore, benefits accruing to one stakeholder group may
impose costs on another. This may be particularly acute when the company has direct
contact with both parties, as when improving employees’ benefits may be expensive
for the shareholders.

A related issue arises from the fact that the interests of different providers of finance
may be in direct conflict. For example, the shareholders enjoy the upside from risky
investments but the lenders do not. A risky investment could be good for the
shareholders, but might undermine the security of the lenders. Similarly, taking on
additional debt in order to finance growth may be in the shareholders’ interests, but
that could dilute the security enjoyed by lenders.

This question was answered well by many candidates.

12 Options give the right to buy or sell the underlying asset, whereas futures require
completion of the transaction at the conclusion of the period. That makes each type of
instrument suitable for dealing with a different type of risk. A future would be
suitable for creating certainty as to the cost of a particular product in the future. For
example, a farmer might use the futures markets to sell a crop for a fixed price at a
specified date. That would mean that the selling price was fixed and the farmer would
be unaffected by a drop in price. However, the farmer could not benefit from any
subsequent increase in the price because delivery would still have to be completed.
An option to sell the product would leave the farmer free to exercise the option if the
price fell below the striking price, but it would also be possible to let the option lapse
and sell at a higher market price. In a sense, the premium paid for an option might be

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 Subject CT2 (Finance and Financial Reporting Core Technical) — April 2007 — Examiners’ Report

thought of as an insurance policy to protect against a specific downside risk , whereas

a future protects against all risks, good and bad.

This question was poorly answered. Many candidates talked about options in detail,
which was not what was asked for. Read the questions carefully, it is worth spending
a bit of time planning an answer rather than just rushing to answer it. Always try to
answer exactly what is being asked.

13 Corporation tax reduces the profit available to pay the shareholders’ dividend.
Borrowing increases the interest charge, which is deductible as an expense for
corporation tax purposes. Some forms of borrowing are very tax-efficient. For
example, lease payments are tax-deductible and provide a more consistent tax benefit
than the effects of raising finance to purchase assets outright and claiming capital
allowances.

The alternative to borrowing is to raise finance from the shareholders. If the company
makes a rights issue it may be difficult for the shareholders to obtain tax relief on any
funds that they borrow in order to buy shares. The shareholders might prefer the
company to borrow on their behalf because the tax benefit is much less likely to be
lost.

This question was answered well by most candidates.

14
Operating profit £500,000
Depreciation 150,000
Increase in inventories -30,000
Decrease in trade receivables 10,000
Increase in trade payables 8,000
£638,000

This question was poorly answered. Most candidates were unsure whether the
increases and decreases in assets and liabilities were inflows or outflows of cash.

15 The company could have invested heavily in non-current assets.

The company could have repaid loan finance during the year.

The company could have paid a substantial dividend out of retained earnings or have
conducted a share repurchase.

The company could have invested heavily in current assets, such as inventory or trade
receivables.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — April 2007 — Examiners’ Report

The profit could be based partly on transactions that do not have a cash effect. For
example, a long term contract could have led to the recognition of profit even though
the related cash payment might not be until some time in the future.

This question was answered reasonably well.

16 Balance sheets reflect two aspects of the business: the assets controlled by it and the
manner in which those assets have been acquired. This means that the assets are
mirrored by capital and liabilities and this yields the balance sheet equation (assets =
capital + liabilities). The accounting system keeps track of the various components of
assets, liabilities and capital so that this relationship is maintained.
The dual aspect concept suggests that every transaction will affect two balances.
Every entry in the books has a corresponding entry which has the effect of
maintaining the balance between assets, liabilities and capital.
The balance sheet is part of the output of the double entry bookkeeping system. This
records adjustments and transactions in such a way that any resulting balance sheet
must balance. Every entry is recorded in two places, to reflect the fact that both sides
of the balance sheet equation must hold true.

The balance sheet is also prepared on the basis of a series of accounting concepts
which means that items are only recorded in response to an event such as a transaction
or an adjustment. This means that the only assets that are listed have automatically
been reflected in the capital and liabilities accounts.

This question was answered very poorly. Most candidates struggled to come up with
more than two points. Very few candidates mentioned double entry bookkeeping or
accounting concepts, which meant they were struggling to come up with any sensible
answer. This is an area where candidates would benefit from some revision before
the next attempt.

17 The going concern assumption effectively permits accountants to prepare financial

statements that make no overt attempt to inform certain potential decisions. For
example, non-current assets are recorded at a carrying value that may bear very little
relevance to decisions such as whether the assets should be sold for their market
values. This is because the going concern assumption takes it for granted that the
assets cannot be sold because the business needs the assets in order to carry on. The
assumption also means that potential errors in short to medium term forecasts and
estimates can be tolerated because the figures will resolve themselves over time. For
example, the inventory is valued on the basis of certain assumptions about its eventual
selling price. Any error might affect the calculation of profit for the current year, but
that will be reflected by a corresponding increase or decrease in the following year
and that should not matter year on year.

In the absence of a going concern assumption, assets would have to be stated at

reasonably current values. That would both complicate the preparation of the
statements and would leave the preparers and auditors more open to challenge in the
event that the values proved to be incorrect.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — April 2007 — Examiners’ Report

This question was also very poorly answered. Very few candidates knew what this
concept meant. Most candidates just talked about solvency and the business
continuing into the future. While this was relevant there was rarely enough detail to
give candidates many marks. The area of accounting concepts is one where
candidates would benefit from revision.

18 There is no agreed definition of the term true and fair. It is absolutely mandatory that
financial statements have this quality, but the lack of a definition means that it cannot
be measured. The various rules and regulations that deal with specific figures and
adjustments provide some guidance, but compliance may not be sufficient in itself.
Indeed, there could be circumstances in which compliance with a specific rule would
be misleading and the preparers would be required to set this aside in the interests of
giving a true and fair view.

The lack of a clear benchmark means that the truth and fairness of the set of
statements may be challenged. Accounts that have been prepared in good faith may
be portrayed as misleading by a decision-maker who feels that s/he has been misled
into making a loss.

This question was answered reasonably, however more depth would have improved
the answers.

19 (i) A company’s market capitalisation is a function of the future expected cash

flows, discounted to take account of the time value of money and risk.
Entering into a positive NPV project has the effect of creating the expectation
of additional future cash flows and these have already been adjusted for the
cost of capital.

The stock market might be viewed as a system that has an incentive to process
information about future cash flows as effectively and as quickly as possible.
Market participants who can spot future gains before their competitors can buy
before the market price catches up with any new disclosures. When it does the
share price will rise and they will have a capital gain. Any bias or error on the
part of speculators will prove expensive because they will suffer losses if the
share price falls after they buy or if any increase is too small to cover the
transaction costs.

The NPV decision rule effectively requires management to consider proposals

on the basis of their effect on shareholder wealth. If management make
correct decisions then shareholders’ wealth will increase, as reflected in
market capitalisation.

(ii) It is highly unlikely that the directors’ disclosures would enable the stock
market to calculate the NPV accurately. Apart from anything else, this would
lead to the publication of commercially sensitive information.

Market participants do not actually value shares on the basis of formal NPV
calculations. Share prices are set by a process of supply and demand, with

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 Subject CT2 (Finance and Financial Reporting Core Technical) — April 2007 — Examiners’ Report

most participants taking note of the buying and selling decisions of other
participants. The relationship between future cash flows and share prices is
sound, but it is more of a long-term benchmark for prices than a measure that
can be reported and valued on a day to day basis. The markets might even
take the view that companies will invest in positive NPV projects as a matter
of course and so share prices might reflect the possibility of such
announcements, even though they have yet to be made.

The markets may not wholly agree with the directors’ opinion of a project.
The directors might be deemed to have an incentive to claim optimism that is
subsequently shown to be unfounded.

(iii) Agency theory suggests that agency costs will eventually be passed on to the
directors in the form of lower salaries or a deflated share price. Information
asymmetry (the fact that directors know more about the running of the
business) is one factor in creating agency costs. Publishing information
enables the directors to signal that their stewardship of the company is sound
and that the shareholders should not be concerned.

Companies are often keen to keep shareholders informed in order to

distinguish themselves from less efficient businesses. Without information,
shareholders have no way of distinguishing well run companies with poor
prospects from those that are better. Voluntary disclosures should enhance the
share price and reduce the risk of a takeover bid motivated by the possibility
that the shares are undervalued.

This question was very poorly answered. This topic has been examined in a
similar fashion for several years now, it is difficult to know why it was badly
done on this occasion. All sections of the question were poor. The answers
lacked any depth.

Again this topic should be revised in detail before the next attempt.

1,200 + 300
20 (i) Gearing = = 58%
1,400 + 1,200

350
Current ratio = = 1.4:1
120 + 100 + 30

350 − 200
Quick ratio = = 0.6:1
120 + 100 + 30

(ii) Cash Ltd’s gearing is much higher than the industry average. That means that
the total risks are much higher. The most obvious reason for this is that the
company must meet the interest payments and loan repayments every year. If
the company has a problem with its cash flows then it will struggle to pay its
debts when they fall due. The fixed interest and preference dividend

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Subject CT2 (Finance and Financial Reporting Core Technical) — April 2007 — Examiners’ Report

commitments will also make the earnings per share more volatile. That means
that the ordinary shareholders will suffer a riskier pattern of dividends.

The liquidity ratios are lower than the industry average. That is a further
reason for the risk to be higher. If the company’s current assets are
insufficient in comparison to current liabilities then the company may struggle
to pay its debts when they fall due. That could lead to the company operating
inefficiently and therefore with greater chance of errors and could make the
business more volatile.

The composition of the assets and liabilities complicates this analysis further.
The company’s bank account is overdrawn. That means that the liquidity ratio
is further cause for concern because the bank might suddenly stop the
company from writing cheques. The overdraft makes it more difficult to
manage the weak liquidity position. On the other hand, a significant current
liability is in the form of a tax liability. The company has several months to
pay this from the balance sheet date. That is a partial source of comfort
because the directors can treat dealing with that payment as a separate exercise
for which they have time to plan and prepare.

(iii) The bank does not wish to risk the company going into default on any loans.
Even if the bank loan is secured on assets or the bank has a floating charge it
is undesirable to have the loan default and have to pay the costs associated
with foreclosing. This will also create adverse publicity for the bank.

The bank might not have security and could rank alongside other creditors in
the event of default. The loan covenant will ensure that the bank’s claim to
the company’s assets is not unduly affected by a disproportionate claim from
other lenders.
The covenant will also give the bank some protection in the event that the
company starts to decline. If there are large losses or asset write-offs then the
covenant might be breached and the bank will be able to claim its money back
before the company’s cash flows give it the right to demand immediate
repayment

This question was very poorly answered. Ratio questions appear frequently in
this paper so candidates who were well prepared should have had little
difficulty with this question. It calls for understanding of the figures and
interpretation of a set of financial statements. Part 3 was poor, this was a
straightforward question, very few candidates discussed the loan covenant,
which was surprising. As this topic tends to be examined frequently some
revision is recommended.

END OF EXAMINERS’ REPORT

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Faculty of Actuaries Institute of Actuaries

EXAMINATION
September 2006

Subject CT2 — Finance and Financial Reporting

Core Technical

EXAMINERS’ REPORT
Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

November 2006

General Comments

The results in this diet were disappointing. The marks were lower than usual and the level of
knowledge shown was poorer than in the past.

Many of the questions were similar to previous diets and were answered poorly.

One of the problems was that some candidates did not answer the questions that were asked.
Reading the questions carefully and making sure the answer is relevant is vital.

There were however some excellent candidates who gave good answers and it was heartening
to see the high level of knowledge demonstrated by them.

Other Comments

Individual comments are shown after each question.

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2006 — Examiners’ Report

1 B
2 C
3 A
4 B
5 C
6 C
7 A
8 A
9 B
10 B

Comments on questions 1–10: These questions were reasonably well answered though few
candidates got full marks.

11 If the company paid a dividend then the shareholders would have to pay income tax
on the whole amount. Any profit made when shares are sold will be subject to capital
gains tax. Capital gains tax only becomes payable once the shares have been sold and
the gain realised. That provides taxpayers with more flexibility in managing their tax
affairs because they have discretion over when they take the gain. Individual
taxpayers have both income tax and capital gains tax allowances. Many taxpayers will
pay income tax on their dividend income because their other income has exhausted
these allowances. The effective tax rate on capital gains may be reduced or even zero
on the basis that they use their annual exemptions.

Comments on question 11: This question was answered reasonably well. Some candidates
concentrated on discussing franked investment income and got poor marks. It was good to
see so many candidates understood Capital Gains tax.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2006 — Examiners’ Report

12 Two methods of medium term finance could be bank loans or leasing. Under a
finance lease, the lessee has the right to use the asset over a period of time, in return
for a regular series of payments. The lessee takes on most of the risks associated with
owning the asset e.g. insuring and repairing the asset. The present value of the
payments under the leasing agreement will be shown as an asset in the lessee’s
balance sheet and as a corresponding liability. A 3–5 year bank loan is also a form of
medium term borrowing. The amount of the loan is paid into the borrower’s bank
account and the borrower will repay capital and interest in regular instalments. The
borrower is then free to purchase the asset of his choice and to seek discounts for
paying in cash. Legal ownership of the asset changes hands immediately.
The interest rate implicit in a lease will usually be fixed and can be higher than a bank
loan. The interest rate on a bank loan is usually variable. A bank loan may lead to a
floating charge over all the assets of the company and the asset would form part of
this security. The asset itself usually provides its own security in the case of a lease,
thereby leaving the other assets available as collateral for other purposes.

Comments on question 12: This question was answered well by most candidates. It is
important to make sure the question is answered, some candidates discussed short and long
term finance which got zero marks.

13 The first problem is in measuring shareholder wealth. This is clearly indicated by the
share price, but that can be a volatile indicator, that is not necessarily affected by just
the company’s efforts to manage the shareholders’ wealth. Furthermore, management
decisions that enhance shareholder wealth will only be recognised in the share price
once the decision itself is announced. This information might be withheld for
commercial reasons.

The second problem is that the directors are often perceived as having their own
interests that are at odds with those of the shareholders. They might have an interest in
enhancing their own rewards at the expense of the shareholders or of avoiding
acceptable risks in order to put their job security before the wellbeing of the
shareholders.

Comments on question 13: This question was not done as well as expected. The question was
straightforward but many candidates only discussed the agency problem and so did not get as
high a mark as they could have.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2006 — Examiners’ Report

14 The principal reason for issuing futures is to enable entities to buy and sell risk, as a
commodity. Futures make it possible to eliminate risk by agreeing to a fixed price for
the acquisition of an asset or the settlement of a liability at a future date. The counter
party to this transaction will benefit by taking the risk in return for a return. Futures
also make it possible to speculate on the size and nature of the volatility in the
underlying commodities. Market participants who believe that they can predict price
movements can often “gear up” such fluctuations by buying or selling futures rather
than the commodities or instruments themselves.

Futures are themselves designed to be traded as financial instruments in their own

right. This facility creates further trading strategies to enable parties to contracts to
modify their positions in a regulated market, with standardised contracts.

Comments on question 14: This question was poorly answered. A significant number of
candidates wrote about different kinds of futures which was not required.

15 Underwriting is a form of insurance and so one important consideration is the

exposure faced by the company if the issue should fail. The directors should consider
the reasons for raising the finance. Withdrawal from a discretionary investment is less
of a problem than withdrawal from one to which the company has made a public
commitment .

The terms of the share issue are important. If the shares are issued at a large discount
to current market prices then there is less risk that demand will fail and so there is less
need for an underwriter. If share prices are volatile then there is a greater risk that
prices will fall below the issue price, thereby rendering the issue a failure and
increasing the need for underwriting.

The cost of the underwriters’ facilities are also an issue. These are likely to be linked
to the risks considered by the directors and so the greater the need for an underwriter
the more expensive the service is likely to be.

Comments on question 15: This question was answered well by most candidates.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2006 — Examiners’ Report

16 The simplest way to create this model would be to identify the variables that might
affect the cash flows from the project. These would be modelled in terms of
probability distributions, which could be represented by random numbers. Where
factors are independent of one another then there will be a separate series of random
numbers for each, otherwise relationships between factors will be built into the model.
The simulation could then be run many times, with different sets of numbers, until a
consistent average outcome and range of good and bad outcomes starts to emerge.

The cash flows themselves would have to be modelled. The cost structure might have
to be modelled in terms of costs associated with different geological or other
problems that might arise with the contract. The probability of each could be linked to
random number tables. The discount rate will also have to be factored in. Discount
rates and costs might be linked via inflation and so the model might have to use one
set of core random numbers.

Comments on question 16: This question was answered well by many candidates, however
some candidates discussed modelling in general and did not appear to know anything about
Monte Carlo simulation. It is vital that candidates answer the question.

17 The biggest area for estimates and assumptions is with respect to determining the
depreciation charge. The company must estimate the expected useful life of the asset
and its estimated residual value. The company must also make assumptions about the
manner in which the value decreases from original cost to the residual value — more
rapid depreciation in the early years requires the use of the reducing balance
approach.

There are also estimates and assumptions implicit in the capitalisation of costs in fixed
assets. There can be some doubt as to whether expenditure is an ongoing operating
cost (e.g. a repair) or part of the cost of acquiring or improving an asset. Some
specific costs, such as the capitalisation of interest, require assumptions about the
progress being made on the asset at any given time.

Many tangible fixed assets are shown at their market values. Such valuations are
almost always a matter for professional judgement because there is rarely an
observable market price for any particular asset or property.

Assets must also be subject to impairment reviews.

Comments on question 17:

This question was straight from the Core Reading and high marks were anticipated. However
many candidates gave disappointing answers. It was surprising to note that many candidates
appeared to find depreciation confusing.

Some revision in this area would be advisable.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2006 — Examiners’ Report

18 The principal test is of whether a company is a subsidiary of another is whether

Company A can control Company B. There are some guidelines for the measurement
of control in the Companies Act and accounting standards. This could happen if
Company A has purchased more than 50% of the voting shares. Control might also
arise if Company A can appoint or remove directors to or from the board of Company
B, particularly if it could control more than 50% of the votes at board meetings in this
way. Company A might also be able to exercise a dominant influence over Company
B, for example by entering into a contract that gives Company A the ability to
exercise control. A holding company would normally have between 20% and 50%
ownership and significant interest to be an associate. These terms are difficult to apply
in practice because control can be difficult to measure and to demonstrate.

Comments on question 18: This question was really well answered by almost all candidates.
Well done!

19 (i) In theory, debt is cheaper than equity because lenders take fewer risks. In
theory, borrowing will reduce WACC because of the higher proportion of
debt. In practice, this might be slightly more complicated because borrowing
will affect the gearing levels and that will affect the risk characteristics of
existing equity. Borrowing will increase the risk of holding shares and that
could increase the cost of equity. At higher levels of gearing the risk attached
to debt might also increase and that could increase the cost of borrowing too.
These additional costs will offset the savings from using the cheaper source of
finance.

Borrowing also carries a tax advantage because interest can be offset against
profit whereas dividends cannot.

The Modigliani and Miller argument suggests that the reduction in WACC due
to borrowing will be exactly offset by overall increases in the cost of equity.
This means that there is no particular cost advantage in using debt or equity.
This argument ignores taxation, though.

(ii) The cost of equity is the rate at which the stock market discounts the cash
flows that are expected from the company. It is impossible to observe market
expectations of cash flows. Most models for arriving at the cost of equity use
past information about dividends and the like to estimate a cost of capital.
Each of those models will generate a different answer and will also require
assumptions about anticipated dividends.

The cost of capital model is also based on share prices which are themselves
quite volatile and might be affected by short term speculative and other market
forces. The cost of equity is likely to be a long-term, underlying factor that is
implicit in the short-term sequence of share price movements.

(iii) Every project should be discounted at a rate that reflects the risks to the
shareholders of making the investment. The WACC might be a suitable
surrogate if the project is a straightforward expansion of the business and is
subject to the same risks.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2006 — Examiners’ Report

The most appropriate basis for the discount rate is to view the project as a
separate investment within a diversified portfolio held by investors. The beta
coefficient of the returns should be estimated and the CAPM should then be
used to determine an appropriate discount rate.

The directors should also consider the stock market’s understanding of the
project . If the stock market thinks that an investment is highly risky then the
share price could go down if the estimated cash flows are subject to a high
implicit discount rate.

Comments on question 19: The first part of the question was answered really well. Parts 2
and 3 were poor. Many candidates just put down the formula for cost of equity and wrote a
very short explanation. Very poor understanding was demonstrated in part 3. Again an area
for revision.

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2006 — Examiners’ Report

20
Report to: Mr Able
Report from: XYZ Financial Advisors
Re: Analysis of Evolution plc’s performance and financial position
Date: X.X.XX

Introduction
In accordance with your instructions we report on the performance and financial
position of Evolution plc for the last two years. Our findings are primarily based
on an analysis of accounting ratios. We would point out that the analysis has
several limitations, since it is based only upon key historical financial
information.

Profitability
The profitability of the company improved over the past two years, with a high
return on shareholders’ equity, and a higher return on investment. The return on
equity has increased from 16% to 21% over the two years, and the return on
investment has increased from 15% to 18%. This shows that the company is
very profitable, as the returns are far better than those offered by risk-free
investments.

The gross profit margin is also healthy and improving, moving from 24% to
25% over the two years. This shows the company is managing its selling prices
and purchasing costs well.

Evolution plc is also controlling its expenses well, having improved its net profit
percentage from 6% in 2004 to 7% in 2005.

Efficiency
Despite the substantial increase in fixed assets during the period (34%), there is
very little change in the fixed asset turnover ratio for the period, both being
around 4 times. The increased investment may reflect replacement of existing
assets or acquisition of additional assets, either of which has given rise to
increased turnover. There may be a further increase in turnover if these assets
have not yet been fully realised.

The net current asset turnover has increased from 4.9 times in 2004 to 7.9 times
in 2005. This indicates a substantial increase in the level of activity being funded
by current assets.

Liquidity
The liquidity position of the company deteriorated over the two year period. The
current ratio fell from 2.1:1 to 1.6:1, and the acid test ratio fell from 1:1 to 0.6:1.
This provides further indication that the 30% increase in sales and the
acquisition of fixed assets was funded from working capital.

The company should raise additional long term finance to ease the company’s
liquidity problems.

There was no change in stock turnover (both years 4.1 times), which suggests

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 Subject CT2 (Finance and Financial Reporting Core Technical) — September 2006 — Examiners’ Report

that the expansion in sales did not lead to a deterioration in the company’s stock
controls.

Gearing
The company is low geared. The debt /equity ratio was .63 in 2004 and .54 in
2005. This is attractive to an equity investor as it is an indicator of low risk.

The interest cover is very satisfactory at 6 times in 2004 and 8.8 times in 2005.
This is also attractive to an investor, as it indicates that the company has not
fully utilised its potential debt facilities.

Return on investment
The company’s earnings per share rose from 26.7 to 40p over the two years, as a
result of Evolution plc’s increased profitability.

The dividend per share remained constant at 10p per share in both years, despite
the increased profitability. This is an indication that the company will be in a
position to pay higher dividends in future years.

Conclusion
Given the high return being offered by Evolution plc and its low gearing, the
company appears to be well managed.

Comments on question 20:

This question was very badly done.

Candidates showed a poor level of knowledge and could not apply that knowledge to the
question. The bulk of the marks available were for commenting on the ratios. Some
candidates did not comment at all and others wrote very brief answers. In these questions it
is the report that is important and is where the candidates can apply their knowledge to a
scenario.

Candidates should revise this area for the future.

END OF EXAMINERS’ REPORT

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Faculty of Actuaries Institute of Actuaries

EXAMINATION
April 2006

Subject CT2 Finance and Financial Reporting

Core Technical

EXAMINERS REPORT
Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M Flaherty
Chairman of the Board of Examiners

June 2006

Comments

Individual comments are shown after each question.

Faculty of Actuaries
Institute of Actuaries
 Subject CT2 (Finance and Financial Reporting Core Technical) April 2006 Examiners Report

1 D
2 A
3 A
4 C
5 A
6 D
7 C
8 A
9 D
10 D

Comments on question 1 19: Generally Q1 10 were well done by most candidates.

11 Return on capital employed is normally regarded as the most reliable measure of

profitability. Given a certain level of investment, it is always better for the business to
generate the highest possible return on that capital. A high ROCE demonstrates
efficient use of a scarce resource. Other ratios might give an insight into profitability,
but they can be difficult to interpret in isolation. For example, the lower gross profit
% in the company implies that it makes less profit from every £1 of sales. That does
not necessarily mean that the company is poorly managed because it could be for
example pricing its sales aggressively in order to increase market share. In spite of the
lower net and gross profit the company has a high return on capital employed. This
suggests that the company is generating good profits from the capital employed in the
company. The capital employed must be relatively lower than others in the industry
and is being used effectively.

Comments on question 11: This question was answered well by most candidates. Very good
knowledge of the return on capital employed ratio was displayed by many candidates.

12 As the company normally pays a steadily increasing dividend it would be a bad signal
to the shareholders if it decided to pay no dividend. The shareholders may lose
confidence in the company and decide to sell their shares. Borrowing to pay a
dividend may not help because the shareholders might interpret this as a sign that the
company is living beyond its means . The suspended dividend would really only
draw attention to the fact that the company is in a period of poor profitability.
Borrowing would also increase gearing which would make the downturn in profit
appear all the more alarming. The interest on any borrowing will also have to be paid
out of future profits, making the return to a normal dividend all the more difficult. The
only advantage to borrowing is that the directors might be able to argue that the need
to repay the loan indicates that they are confident of returning to profit.

Comments on question 12: This question was also very well answered by most candidates.
Excellent knowledge of the agency problem was demonstrated.

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 Subject CT2 (Finance and Financial Reporting Core Technical) April 2006 Examiners Report

13 Agency theory, which considers the relationship between a principal and an agent of
that principal, includes issues such as the nature of the agency costs, conflicts of
interest (and how to avoid them) and how agents may be motivated and incentivised.
These issues arise because the shareholders must put the directors in a position of
trust, but the directors will usually have an incentive (or at least a perceived interest)
to act in his or her own interests at the expense of the principal s. For example by
taking a high salary from the company and paying a lower dividend.
The need to rely on directors arises because of the development of a commercial
environment which requires the separation of ownership and control. The directors
run the company on behalf of the shareholders who own it. Many companies are
simply too large and complex for them to be funded by a small group of shareholders
and managed by the same small group.

The principals often have to rely on monitoring the actions of the agents with the
underlying threat of some penalty for failure or poor performance. The annual report
is often viewed as a means of the agents (directors) demonstrating their stewardship
of the principals (shareholders ) investment. However it is often difficult to
determine whether the directors have improved matters short term but have sacrificed
long term gains to achieve this.

Comments on question 13: This question was also very well answered by most candidates.
Excellent knowledge of the agency problem was demonstrated.

14 In theory, incorporation would limit the liability of the actuaries. Lenders would have
a claim against the company s assets but not those of the individuals who own it. This
advantage could prove costly though. Lenders will perceive a higher risk. They might
respond by charging a higher rate of interest which will, eventually lead to lower
profits for the consultants. They might also seek additional security over assets,
thereby imposing some constraints on the consultants freedom to trade. They might
even demand personal guarantees from the consultants so that they become liable for
the loans despite the incorporation.

Even if the lenders did not take action to protect themselves, limited companies are
subject to some additional regulatory requirements that have to be set against the
benefits of limited liability. For example, limited companies are subject to some
reporting and filing requirements that partnerships are not. This would involve paying
to put trading information in the public domain, where it might prove useful to
competitors or other parties. It appears that incorporation would be costly and may not
result in limited liability.

Comments on question 14: Again this question was answered well. Many candidates also
discussed the benefits of a limited liability partnership, which demonstrated a good
knowledge of the core reading and its application to different scenarios.

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 Subject CT2 (Finance and Financial Reporting Core Technical) April 2006 Examiners Report

15 Firstly, the directors will have to appoint a suitable finance house to make the
necessary arrangements and to provide advice and support as required. The timing of
the issue will have to be considered, as well as how much is required to be raised.
Ideally, the funds will have to be raised just before they are required, although there
could be issues associated with timing such as the state of the markets or the
uncertainties created by other matters (such as a forthcoming earnings announcement)
that might upset the markets. The directors will have to decide on the size of the
discount to be offered. In theory, this should have no effect on the shareholders, but
there could be some market psychology at work. The directors will also have to
decide whether or not to have the issue underwritten.

Comments on question 15: This question was answered well.

16 The company s stated reasons should be examined. This offer appears to offer a
concession, but it may be that it is intended to help the board survive a cash shortage
or some other problem with profitability. The investor should also consider the
strength of the company. At present the bond provides most of the rights associated
with holding loan stock. There is more security associated with leaving the investment
as it is. The company s prospects should be reviewed in some detail. If the company
appears to be expanding and is paying acceptable dividends then the conversion could
be advantageous. If the investor converts the interest on the bond will be foregone and
so the interest rate should also be factored into the decision.

Comments on question 16: This question was not answered as well as some others. Some
candidates wrote about bonds in general but very little about conversion, they did not
achieve high marks for this question.

17 Probability trees and simulations are used to organise complex decisions where the
choices available at any stage will be affected by decisions made at earlier stages. For
example, a company can invest in an investment opportunity. Before committing
itself it can decide whether or not to purchase a report which will cost a great deal but
will enable the company to make a more reliable assessment of the project. A
probability tree or simulation will enable management to decide whether it is better to
go ahead or abandon the project without buying the report or whether to buy the
report before making a decision.

The probability tree or simulation would involve the following steps which would not
be objective as they each involve subjective judgement.

assigning estimated cash flows associated with each future possible choice
estimating the probabilities associated with each future cash flow
using standard expected value calculations, incorporating both the time value of
money and the probabilities, to assess the optimal choices in each future time
period based on the knowledge of the intervening events
working backwards from the latest decision point to the present day in order to
establish the best (e.g. highest NPV) route to follow at the outset

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 Subject CT2 (Finance and Financial Reporting Core Technical) April 2006 Examiners Report

It is impossible for the result to be anything but an estimate when so many subjective
figures are used to arrive at a result.

Comments on question 17: This question was not answered very well. Few candidates
mentioned the subjective nature of any predictions of future cash flow. Some candidates
mentioned being objective but a discussion of the subjective nature of the whole model would
have improved the answers.

18 The P/E ratio is an important indicator of the stock market s opinion of a company s
prospects. It is largely determined by the share price, which is a function of the
market s expectations of future cash flows. Increasing the profit figure by adopting a
new accounting policy could have no effect on share price because that will not
improve the prospects of increased cash flows. Thus, artificially increasing earnings
per share though an accounting change is more likely to reduce the P/E ratio because
the share price is unlikely to change if everything else stays the same.

It is possible that the accounting change will lead to a short-term increase in share
price while the market takes time to reflect on the effects of the new policy. In
principle, if the effects of the new policy were difficult to measure then this could
continue for some time, but the market is driven by analysts who have a strong
incentive to find such changes and to sell over-priced securities, so the effects of
accounting policy changes are unlikely to be more than short-lived.

Comments on question 18: This question was answered very well by most delegates. Very
clear discussion of the P/E ratio by almost all candidates which was good.

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 Subject CT2 (Finance and Financial Reporting Core Technical) April 2006 Examiners Report

19 (a) Portfolio theory states that the return offered by an individual investment is
related to the risk associated with it. Risk is measured in the context of
systematic risk only, because unsystematic risk can be cancelled by
diversification. The market will not offer a reward for accepting unsystematic
risk because it can be dealt with at zero cost. The fact that the investment is to
be in the relative s employer makes the risks even worse because a downturn
could affect both the investment and job security. There is even a cost
associated with attempting to manage an investment in the active way implied
by the relative. Using knowledge of the business implies a trading strategy
based on gathering and evaluating information. A buy and hold strategy based
on a diversified portfolio would reduce the need to make decisions about
buying and selling shares and should save on information and trading costs.

(b) The capital markets offer a return that compensates for deferring consumption
(roughly 2% in real terms), plus a premium for risk. Market forces set a fair
price for the risks taken. An investment that offered a higher return than was
justified by the risk taken would be underpriced. Investors would realise this
and would buy the security, thereby pushing up the price. That would reduce
the return offered by the security to its equilibrium price. Speculators and
arbitrageurs monitor the financial markets for mispriced securities so that they
can make short-term profits. In theory, capital markets are efficient, which
means that securities will always be correctly priced at all times.

(c) The family member will be taxed on any dividend at his marginal rate of
income tax. That tax will be almost impossible to avoid and he will have
relatively little control over the timing of receipts and, by implication, of
taxable income. The taxation of capital gains is rather more complicated.
Firstly, the gain will not be taxed until the shares are sold and the gain is
realised. That, in itself, gives the taxpayer more discretion over the
management of payments to the tax authorities. Taxpayers also have separate
annual allowances for capital gains, quite separate from allowances from
income tax. If a realised gain is less than the annual allowance then the gain
will be effectively tax free. In some cases, the chargeable gain will be reduced
by an indexing allowance to adjust for the effects of inflation.

Comments on question 19: This question was very poorly answered. A number of candidates
answered part a by discussing CAPM and did not mention portfolio theory. Few candidates
appeared to have heard about efficient markets and had very poor answers for b. C was very
badly answered by all but the best candidates. The best candidates gave excellent answers
but the rest had difficulty with this question. It would be beneficial to have knowledge of this
part of the syllabus for the future.

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 Subject CT2 (Finance and Financial Reporting Core Technical) April 2006 Examiners Report

20 Trolley Ltd

Profit and loss account for the year ended 31 December 2005

Note £000

Turnover 22,356
Cost of sales 1 (15,905)
Gross profit 6,451
Distribution costs 2 (1,310)
Administrative expenses 3 (2,186)
Operating profit 2,955
Interest payable 4 (210)
Profit on ordinary activities before taxation 2,745
Taxation (500)
Profit on ordinary activities after taxation 2,245
Dividends paid (32)
Dividends proposed 5 (192)
Retained profit for the year 2,021
Retained profit brought forward 1,360
Retained profit carried forward 3,381

Trolley Ltd

Balance sheet as at 31 December 2005

Note £000 £000

Fixed assets
Tangible fixed assets 6 5,664

Current assets
Stock 1,870
Debtors 7 1,965
3,835
Creditors: amounts falling due within one
year 8 (2,318)
Net current assets 1,517
7,181
Creditors: amounts falling due after more
than one year
10% Debentures 2009 (1,400)
5,781

Share capital and reserves

Called up share capital 2,400
Profit and loss account 3,381
5,781

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Subject CT2 (Finance and Financial Reporting Core Technical) April 2006 Examiners Report

Working Notes

£000
1. Cost of sales
Opening stock 1,700
Add: purchases 15,250
Factory rent rates and insurance (438 - 6/12 * 90) 393
Heat and light (426 + 6) 432
Less: closing stock (1,870)
15,905

2. Distribution expense
Van drivers wages 800
Advertising 350
Depreciation delivery vehicles 160
(20% (960 160)) 1,310

3. Admin expenses
Admin wages and salaries 1,240
Telephone 420
Audit fees 150
Depreciation property (2% 3.8m) 76
Depreciation machinery (10% 3,000k) 300
2,186

4. Interest
Debentures (10% 1,400k) 140
Bank overdraft interest 70
210

5. Proposed dividends
Ordinary 3.2m shares @ 50 pence 160
Preference ((8% 800) 32) 32
192

6. Tangible fixed assets

Property Plant and Vehicles Total
Machinery

£000 £000 £000 £000

Cost at 1 Jan 2005 3,800 3,000 960 7,760

Depreciation at 1 Jan 2005 500 900 160 1,560
3,300 2,100 800 6,200
Depreciation charge for the year 76 300 160 536
WDV at 31 Dec 05 3,224 1,800 640 5,664

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 Subject CT2 (Finance and Financial Reporting Core Technical) April 2006 Examiners Report

7. Debtors
£000

Trade debtors 1,920

Insurance prepayment 45
1,965

8. Creditors due within one year £000

Trade creditors 690

Electricity accrual 6
Debenture interest 70
Corporation tax 500
Proposed dividends 192
Bank overdraft 860
2,318

Comments on question 20:

This question was answered well apart from the accrual and prepayment, which caused some
problems. Generally the question was well done and most candidates got high marks.
It was good to see so many candidates can prepare a set of accounts and have awareness of
the format.

Overall the paper was answered well by many candidates. There were some fairly small
areas, which caused problems but overall it was heartening to see good performances by so
many candidates.

END OF EXAMINERS REPORT

Page 9
Faculty of Actuaries Institute of Actuaries

EXAMINATION
September 2005

Subject CT2 Finance and Financial Reporting

Core Technical

EXAMINERS REPORT

Faculty of Actuaries
Institute of Actuaries
 Subject CT2 (Finance and Financial Reporting Core Technical) September 2005 Examiners Report

1 B
2 A
3 D
4 D
5 C
6 D
7 C
8 A
9 C
10 B

11 The arguments to support scrip issues are largely psychological.

Marketability: By having more, lower priced shares, the marketability is improved.

Something for nothing: Shareholders might like the idea of being given extra shares
free of charge.

Past profitability: Scrip issues can take place only if there are sufficient reserves to be
capitalised. This means that scrip issues tend to be associated with successful
companies which have built up large reserves from retained profits.

Future confidence: The minimum price at which a rights issue can occur is the par
value of the shares. Yet rights issues must occur at a discount. Therefore, a rights
issue is only possible if the current share price is above the par value of the shares. A
scrip issue reduces the price of a share. Therefore, having a scrip issue may reduce a
company s ability to have a future rights issue if its share price declined following the
scrip issue. So, if the directors decide to have a scrip issue, they must be confident
about the company s future prospects.

Increased dividends: Some companies have a habit of having light scrip issues
(e.g. 1 for 10) and subsequently keeping the same dividend per share. In these cases, a
scrip issue may lead to, or be a sign of, higher dividends.

More reasonable rate of dividend: If dividends are expressed as a percentage of the

nominal value the figure may seem excessive. This could cause public relations
problems, or problems with employees who feel that dividends are too high. This
could be avoided by a scrip issue.

It is a requirement of the Companies Act 1985 that a company must have a minimum
issued share capital of £1m before it can act as a trustee. A scrip issue converts
reserves into share capital, so may allow a company to meet this requirement.

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 Subject CT2 (Finance and Financial Reporting Core Technical) September 2005 Examiners Report

12 A qualified audit report means that the auditor has expressed some reservations about
the truth and fairness of the financial statements.

The most common reason for a qualified report would be that the auditor disagrees to
a material extent with the information in the statements.
The audit report would normally state that the financial statements give a true and fair
view except for the subject matter of the disagreement.
In extreme cases the auditor might state that the financial statements do not give a true
and fair view.

The significance of such an audit report depends on the reaction of readers. In

principle, they must decide whether to rely on the figures provided by the directors or
the auditor.
The fact that the auditors have disagreed with the directors so publicly might
undermine investor confidence in the integrity of the board
and so the share price might fall.
The directors might also be left with a weaker reputation in future years.

13 One approach to deriving the cost of equity is based on the capital asset pricing
model.
Cost of equity = Risk free rate + (Equity risk premium Beta for stock).

The risk free rate is determined by analysing the real rates of return on risk-free
investments such as government securities.
The equity risk premium is determined by the historical average return on equities.

The beta is determined by analysing the historical sensitivity of the return on the
company s securities to the returns on the market as a whole.
If the company s returns fluctuate more widely than market returns the company s
shares will be regarded as more risky and a higher rate of return will be required.

This model assumes that historical sensitivity is a valid measure of the market s
perception of the future risk.
It also assumes that the markets are interested only in systematic risk.

Note accept alternative models such as dividend growth or APT, even if not
covered in core reading.

14 The group has no legal identity; it is merely an accounting abstraction.

It is not possible to enter into a contract with the group as such, only with one or more
of the individual companies in the group.
Each group member is protected by limited liability and is not liable for the debts of
its fellow group members.

Lenders might ask for guarantees so that group members had a contractual duty to
support their fellows.

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 Subject CT2 (Finance and Financial Reporting Core Technical) September 2005 Examiners Report

That will only be effective if the funds in the group are freely available for that
purpose. For example, an overseas subsidiary might be unable to remit funds to the
head office.

Or the minority shareholders in a subsidiary might be able to interfere with a transfer

to another group member.

The financial statements for a group of companies are more complex than those for an
individual company, which are usually easier to understand.

15 Agency theory, which considers the relationship between a principal and an agent of
that principal, includes issues such as the nature of the agency costs, conflicts of
interest (and how to avoid them) and how agents may be motivated and incentivised.

These issues arise because the principal must put the agent in a position of trust, but
the agent will usually have an incentive (or at least a perceived interest) to act in his
or her own interests at the expense of the principal s.

The need to rely on agents arises because of the development of a commercial

environment which requires the separation of ownership and control.
Many companies are simply too large and complex for them to be funded by a small
group of shareholders and managed by the same small group.

In practice, the various mechanisms for making the agent s interests coincide with
those of the principal are flawed.
This means that principals often have to rely on monitoring the actions of the agents
with the underlying threat of some penalty for failure or poor performance.
The annual report is often viewed as a means of the agents (directors) demonstrating
their stewardship of the principals (shareholders ) investment.

16 Return on capital employed is normally regarded as the most reliable measure of

profitability.
Given a certain level of investment, it is always better for the business to generate the
highest possible return on that capital.
Other ratios might give an insight into profitability, but they can be difficult to
interpret in isolation.
For example, the higher gross profit % in P plc implies that it makes more profit from
every £1 of sales.
That does not necessarily mean that the company is better managed because it could
be overpricing its sales in order to achieve that result.
Similarly, the net profit % figures suggest that P plc is spending less on non-trading
operating expenses than D plc,
but that could be a false economy. D plc might be making a conscious investment in
better administrative systems and in promotion and advertising and that might be a
further explanation for the higher returns that it is enjoying.

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 Subject CT2 (Finance and Financial Reporting Core Technical) September 2005 Examiners Report

17 Employees are generally regarded as stakeholders,

as is government.

Employees are interested in the company s ability to offer them satisfactory terms and
conditions of employment and in their job security.
The shareholders are usually more interested in making a profit and might be keen to
see the company outsource some tasks or even move them offshore.

The government is interested in the company s social and economic contribution and
also its ability to pay taxes.
Again, the shareholders might prefer to have the company relocate to an easier tax
regime or to claim substantial grants and other support in order to obtain higher
profits and dividends.

Credit was also awarded for discussion of other stakeholders (e.g. directors,
creditors, debtors).

18 Debentures are normally secured against assets and so there is very little risk of
default.
This security might be a fixed charge against specific assets or a floating charge over
the assets generally.
Regardless of this, the debenture holders normally rank ahead of most other creditors
in the event of a default.

The debenture will normally give the holder the right to a fixed annual or six-monthly
interest payment.
If this is not paid then there are normally clear agreements to enable the holder to
force the company to make payment.

Debentures are not totally risk free investments, though. Their value arises from
providing a highly predictable series of cash flows. The value of that series will
fluctuate in accordance with the risk-free rates offered on the markets.
If interest rates rise then the cash flows from the debenture will have to be discounted
at a higher rate and a capital loss will ensue.

19 (i) The most likely explanation is that the directors do not have sufficient positive
NPV projects to invest in.
Retaining the cash in the company without putting it to good use will
undermine their return on capital employed.
That would lead to dissatisfaction from the shareholders
and could even lead to an attempted takeover.

The distribution might also demonstrate the integrity of the board.

They are clearly good stewards if they prefer to act in the shareholders best
interests rather than hoard cash for their own sake.

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 Subject CT2 (Finance and Financial Reporting Core Technical) September 2005 Examiners Report

(ii) (a) The stock market reaction will depend on the interpretation of the
facts. Presumably the fact that the company had substantial cash
reserves was known.
The market would have had some expectations that this cash would be
put to some use.
If the market believed that the funds would be invested in highly
profitable projects then the announcement that they will be returned as
a cash distribution will depress the market price.
If the market had lacked confidence in management s ability to invest
these funds successfully then the share price might rise.
For example, the market might have anticipated that this cash would be
used to fund some expansion through takeover. This usually involves
considerable expense and takeovers are rarely wholly successful.

In the short term, the stock market might take some time to adjust to
this announcement. It is an unusual step and it might be regarded as a
lack of self-confidence on the part of management.

(b) The share price will fall just after the payment because the company
will be buying the shares back at a small premium.
By the time of the repurchase the shares will have value partly because
of the repurchase
and partly because of the future cash flows to be generated from the
remainder of the company.

(iii) If the company paid a major dividend then the shareholders would have to pay
income tax on the whole amount.
The repurchase will constitute a partial disposal, and any profit will be subject
to capital gains tax.
That is often less onerous, particularly for individual tax payers. Depending on
the original cost of the shares, some shareholders might even make a capital
loss on this disposal and so there will be no tax liability.

The directors might also wish to ensure that this is viewed as a highly
abnormal event.
The use of an unusual form of distribution might help to signal that the
company will not be making any similar disbursements in the foreseeable
future.

(iv) The advance warning will avoid any panic-stricken reactions.

The time scale makes it clear that there will be ample opportunity for
consultation and discussion,
including at least one annual general meeting.

The period of warning will also enable investors to make their own
arrangements in the meantime. Those wishing to avoid recognising a capital
gain in 18 months time will have the option of selling their holding now
and possibly spreading the capital gain. They will also be able to start
planning how best to invest or manage the cash that will be released.

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 Subject CT2 (Finance and Financial Reporting Core Technical) September 2005 Examiners Report

20 (a)
JK plc
Profit and Loss Account
for the year ended 31 August 2005
£000 £000
Sales 2,200
Cost of sales (1,284)
Gross profit 916
Administration (395)
Distribution (145)
(540)
Operating profit 376
Income from investments 20
Interest (9)
Net profit before taxation 387
Taxation (25)
362
Dividend (60)
302
Balance brought forward 374
676

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 Subject CT2 (Finance and Financial Reporting Core Technical) September 2005 Examiners Report

JK plc
Balance Sheet
as at 31 August 2005
£000 £000
Fixed Assets
Tangible 1,281
Investments 450
1,731

Current Assets
Stock 180
Debtors 134
Bank 8
322

Creditors: amounts due within one year

Taxation (25)
Creditors (52)
(77)
Net current liabilities 245
1,976
Loan (400)
1,576

Share capital 900

Profit and loss account 676
1,576

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Subject CT2 (Finance and Financial Reporting Core Technical) September 2005 Examiners Report

Note Fixed Assets

Cost Aggregate Net book
depreciation value
£000 £000 £000
Land and buildings 1,200 (39) 1,161
Machinery 250 (130) 120
1,450 (169) 1,281

Workings
Cost of sales
Opening stock 210
Materials 800
Closing stock (180)
830
Depreciation (30 + 24) 54
Wages 400
1,284

Admin
Directors' salaries 85
Head office running costs 200
Wages 110
395

Distribution
Advertising 90
Wages 55
145

(b) Companies are liable to corporation tax on their taxable profits.

Taxable profits include both income (less expenses) and capital gains.

The starting point for a company s tax assessment is profit on ordinary

activities before taxation.
This figure then needs to be adjusted.

The main adjustments are:

add back any business expenses shown in the accounts which are not
allowable for tax
add back any charge for depreciation, and instead subtract the allowable
capital allowance

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 Subject CT2 (Finance and Financial Reporting Core Technical) September 2005 Examiners Report

deduct gross franked investment income

Franked investment income is income paid by UK companies as a distribution

of their post-tax profits together with an attaching tax credit. The company
paying the dividend has already paid corporation tax on the profits from which
the dividend is paid. The purpose of the tax credit is to reflect the fact that the
dividend is paid from post tax profits.

END OF EXAMINERS REPORT

Page 10
Faculty of Actuaries Institute of Actuaries

EXAMINATION
April 2005

Subject CT2 Finance and Financial Reporting

Core Technical

EXAMINERS REPORT

Introduction

The attached subject report has been written by the Principal Examiner with
the aim of helping candidates. The questions and comments are based around
Core Reading as the interpretation of the syllabus to which the examiners are
working. They have however given credit for any alternative approach or
interpretation which they consider to be reasonable.

M Flaherty
Chairman of the Board of Examiners

15 June 2005

Faculty of Actuaries
Institute of Actuaries
 Subject CT2 (Finance and Financial Reporting Core Technical) April 2005 Examiners Report

1 B
2 A
3 C
4 D
5 C
6 D
7 C
8 C
9 D
10 B

11 The principal test is whether Company A can control Company B.

There are some guidelines for the measurement of control in the Companies Act and
accounting standards.
This could happen if Company A has purchased more than 50% of the voting shares.

Control might also arise if Company A can appoint or remove directors to or from the
board of Company B,
particularly if it could control more than 50% of the votes at board meetings in this
way.
Company A might also be able to exercise a dominant influence over Company B,
for example by entering into a contract that gives Company A the ability to exercise
control.

12 Probability trees are used to organise complex decisions where the choices available
at any stage will be affected by decisions made at earlier stages.
For example, a company can invest in an investment opportunity. Before committing
itself it can decide whether or not to purchase a report which will cost a great deal but
will enable the company to make a more reliable assessment of the project.
A probability tree will enable management to decide whether it is better to go ahead
or abandon the project without buying the report or whether to buy the report before
making a decision.

The probability tree would involve the following steps:

mapping the possible choices, beginning from the initial project decision and
branching out to represent all the possible subsequent options
assigning estimated cashflows associated with each future possible choice
estimating the probabilities associated with each future cashflow
using standard expected value calculations, incorporating both the time value of
money and the probabilities, to assess the optimal choices in each future time
period based on the knowledge of the intervening events
working backwards from the latest decision point to the present day in order to
establish the best (e.g. highest NPV) route to follow at the outset

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 Subject CT2 (Finance and Financial Reporting Core Technical) April 2005 Examiners Report

One use of the probability tree would be to organise the various aspects of this
complex series of decisions that have to be made in order to reach a conclusion.

13 The role of the external auditor is to add some credibility to the financial statements
published by the company.
The auditor expresses an independent opinion on the truth and fairness of the financial
statements.
This opinion is based on both detailed testing of the bookkeeping records
and an analysis of the accounting policies that have been used to prepare the
statements.
If the auditor s reported opinion supports the figures then shareholders should have
fewer concerns about the accuracy of the figures or the basis on which they have been
prepared.
This reassurance makes the capital markets more open than they would otherwise be.

Any monitoring or covenants based on published accounts will be regarded as more

effective if the statements are supported by such an opinion.

14 The markets demand an adequate rate of return from an investment.

Essentially, stock market prices reflect both the market s projections of cash flows
from the investment
and the discount rate that should be applied to these.
The quality of management can affect both the size of expected cash flows and the
risks associated with them.
If managers are seen to under perform then the share price will fail to rise, or even
fall.
That could open the way to a takeover bid from someone who wants the opportunity
to run the company more efficiently.
The buyer would then dispose of the existing management team.
There can be more immediate market disciplines. Managers are often paid in stock or
stock options.
Their performance will have an effect on the value of the financial instruments
granted to them as part of their remuneration.

15 Companies are liable for corporation tax whereas the partners in a partnership pay
income tax on their share of the profits.
The effective tax rates for the partners post-incorporation may be higher or lower.
Companies are taxed on their income plus capital gains. Partnerships do not pay
income tax on capital gains, although individual partners may pay capital gains tax on
their share of gains.
The starting point for tax for a limited company is profit from ordinary activities
before taxation. This is then adjusted for any non-allowable expenses, depreciation is
added back and gross franked investment income is deducted.
One of the main differences in the taxation of limited companies is the treatment of
dividends. Franked investment income is dividends received plus a tax credit of 10%.
The tax credit is given to recognise that dividends are paid from post tax profits.

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 Subject CT2 (Finance and Financial Reporting Core Technical) April 2005 Examiners Report

The imputed tax system ensures that there is no disadvantage suffered by the
shareholders when a company distributes profit.

As directors the former partners would pay income tax on their salaries and the
company pays corporation tax on the remaining profits.
The partners would previously have paid income tax on the whole profits.

16 In theory, incorporation would limit the liability of the consultants. Lenders would
have a claim against the company s assets but not those of the individuals who own it.

This advantage could prove costly though. Lenders will perceive a higher risk.
They might respond by charging a higher rate of interest which will, eventually lead
to lower profits for the consultants.
They might also seek additional security over assets, thereby imposing some
constraints on the consultants freedom to trade.
They might even demand personal guarantees from the consultants so that they
become liable for the loans despite the incorporation.

Even if the lenders did not take action to protect themselves, limited companies are
subject to some additional regulatory requirements that have to be set against the
benefits of limited liability.
For example, limited companies are subject to some reporting and filing requirements
that partnerships are not.
This would involve paying to put trading information in the public domain, where it
might prove useful to competitors or other parties.

17 (a) The option holders have the right to buy shares at the striking price. They will
almost certainly exercise those rights if the market price exceeds the striking
price.
Buying shares at a discount to the market price will spread future profits over
more shares.
The corresponding investment made by the option holders will probably be
insufficient to compensate for the broader shareholding,
hence the value of existing shares will be diluted . Effectively, this means
that H s investment might fall in value at some future date because of the
options.

(b) The current market price of the shares will reflect the fact that these options
are outstanding.
That means that H will not actually subsidise or pay for the effect of these
options.
If the options expire unexercised then H will benefit from this discount and
will not bear any cost.
On the other hand, if the share price rises then the potential upside will be
limited to some extent by the effect of the options.
That might affect the overall risk profile of the investment.

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 Subject CT2 (Finance and Financial Reporting Core Technical) April 2005 Examiners Report

18 (a) The most obvious way in which to reduce beta is to diversify.

The company should move into lines of business that are as dissimilar from
existing lines as possible.
The company could even conduct a historical analysis to find businesses or
industries that tend to move in the opposite direction to Cappemm plc over
time.

(b) It is unlikely that reducing beta in this way will attract investors. Investors can
diversify for themselves.
It is unlikely that they will pay a premium for this reduction. They might also
be put off by the fact that Cappemm s management will be responsible for a
substantial investment in an industry that they know little about.
The risks associated with this will be specific risks that can be diversified
away,
but the costs of managing this company will reduce profit and that will make
the investment less attractive.

Shareholders looking to build a clearly diversified portfolio might actually be

more attracted to the company that has a clear investment strategy.
They might prefer this to an artificial diversification offered by Cappemm s
new policy.

19 (i) (a) The company might have a standard hurdle rate for all capital projects.

This might take account of the cost of the company s capital.

It might even take account of the systematic risks associated with
investing in the company as identified by the company s beta.

Essentially, the discount rate should reflect the risks associated with
the project
and also the need to generate a real rate of return from the capital that
has been invested.

(b) The most appropriate rate will be specific to the risks associated with
the project itself.
Standard rates based on the company itself are not really relevant
because each project will have its own risks and rewards.

(ii) In theory, debt is cheaper than equity because lenders take fewer risks.
In theory, borrowing will reduce WACC because of the higher proportion of
debt.
In practice, this might be slightly more complicated because borrowing will
affect the gearing levels and that will affect the risk characteristics of existing
equity.
Borrowing will increase the risk of holding shares and that could increase the
cost of equity.
At higher levels of gearing the risk attached to debt might also increase and
that could increase the cost of borrowing too.

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 Subject CT2 (Finance and Financial Reporting Core Technical) April 2005 Examiners Report

These additional costs will offset the savings from using the cheaper source of
finance.

Borrowing also carries a tax advantage because interest can be offset against
profit whereas dividends cannot.

The Modigliani and Miller

argument suggests that the reduction in WACC due to borrowing will be
exactly offset by overall increases in the cost of equity.
This means that there is no particular cost advantage in using debt or equity.

This argument ignores taxation, though.

(iii) The models used to evaluate investment projects require many highly
subjective decisions to be made about the parameters that are to be used in the
model.
In practice, that often means that any particular project can be justified by
adjusting estimates about the projected cash flows
and the appropriate discount rate.
Companies may have formal investment appraisal systems but their
implementation may be influenced by the political status of the individuals
or the department that is sponsoring the project.
Apart from forecasting and capital considerations, arguments can be put
forward to use more basic techniques such as payback for certain projects
or to dispense with formal appraisal altogether because the project is required
for safety or for strategic purposes.
Some projects may not be individually profitable, but may be undertaken
because they are considered to benefit the company as a whole.
Sometimes a project may be undertaken to achieve synergy or compatability
with other projects undertaken by the company.

20 (i) The valuation on the basis of profit times a notional price/earnings ratio takes
account of the future earnings potential of the company.
Arguably, the P/E ratio effectively discounts all future earnings back to their
NPV.
This approach could be influenced by the accounting policies of the
companies involved
but is otherwise theoretically sound because nothing is omitted from the
calculation.

The P/E model ignores the possibility that the deceased proprietor may have
had a substantial input into the earning capacity of the business.
His absence may reduce future profits.
It also ignores the possibility that the son who inherits the business may have
to work full-time in order to bring about the future profits and this model
would include the value of his labour along with the inherent value of the
company.

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Subject CT2 (Finance and Financial Reporting Core Technical) April 2005 Examiners Report

The asset based valuation restricts the valuation to those assets that can be
measured in the financial statements.
It ignores factors such as goodwill and staff skills.
It is also highly open to influence from accounting estimates and assumptions.

The asset basis may be more appropriate if the business is to be sold as it

stands and if the new owner will have to replace the input provided by the
founder.

(ii) Given that the P/E model takes account of all of the future cash flows and
profits,
it would normally give a much higher valuation than the asset basis.

(iii) With most information gathering systems there is normally a trade-off

between reliability and cost.
Financial statements are prepared on the basis of historical costs because these
can be determined reasonably quickly and easily.
They are not necessarily the most relevant basis for most decisions, but it is
argued that they are generally prepared for stewardship purposes
and so any inaccuracy is unlikely to undermine their relevance.
Past performance is not necessarily a guide to future performance, and it is
future performance that is relevant to valuations.

The financial statements are generally prepared on the basis of highly

subjective estimates about such issues as asset lives.
These could have a significant impact on the profit figure and balance sheet
valuations, all of which could affect any company valuation.
Typically, financial statements omit balances, such as internally generated
goodwill,
which would be difficult to value in any meaningful way. That further
undermines their relevance to company valuations.

(iv) All companies confer the privilege of limited liability on their owners.
It is important that anyone dealing with the company has some protection from
the potential abuses associated with limited liability.
Reliable financial statements are one such source of protection, particularly
when combined with agreements that can be expressed in terms of accounting
numbers.
For example, a bank might grant a loan in return for an agreement that the
gearing ratio will be kept below a particular percentage.

The financial statements enable shareholders to make decisions about their

relationship with the company.
They can decide whether to support the present management or call for a
change on the basis of the figures in the annual report.

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 Subject CT2 (Finance and Financial Reporting Core Technical) April 2005 Examiners Report

Companies also require financial statements in order to pay tax.

It would be difficult for tax authorities to know how much to levy without
formal financial statements.

END OF EXAMINERS REPORT

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