Actuarial Society of India

Examinations

May 2006

CT2 – Finance and Financial Reporting

Indicative Solutions
CT2 0506

Que 1-10

Sol 1 D
Sol 2 D
Sol 3 D
Sol 4 C
Sol 5 A
Sol 6 C
Sol 7 C
Sol 8 A
Sol 9 B
Sol 10 A
[Each carries 2 ma rks total 20]
Que 11)

A Eurobond is a bond issued in the Euromarket. A Eurobond is marketed internationally,

mainly by London branches of international banks. (1)

Preference shares are much less common than ordinary shares. Overall, preference shares
are much less important than ordinary shares. The investment characteristics are more often
like those of unsecured loan stocks than ordinary shares. Assuming that the company makes
sufficient profits, they offer a fixed stream of franked investment income. Preference shares
pay a fixed dividend, and so can be regarded as a form of fixed-interest stock. The dividend
is usually expressed as a fixed percentage of the par value, so when we refer to the
“dividend” from preference share it is more akin to an interest payment on a bond than to a
dividend on an ordinary share. They do not usually carry voting rights.

Preference shareholders have a preferential right to either dividends, or return of capital, or

both, compared to ordinary shareholders. (1)

Convertible forms of company securities are, almost invariably, unsecured loan stocks or
preference shares that convert into ordinary shares of the issuing company. Convertible
preference shares are preference shares which give the right to convert into ordinary shares at
a later date. The investor does not pay anything to convert other than surrendering the
convertible preference shares. Convertible unsecured loan stocks are unsecured loan stocks
which give the right to convert into ordinary shares of the company at a al ter date. For
example, Rs 100 nominal of convertible unsecured loan stock might be convertible into, say,
30 ordinary shares on 1st October 2006.

The only difference between convertible loan stocks and convertible preference shares is the
form of the capital before it converts into equity. Convertible loan stocks are part of loan
capital until conversion, whereas convertible preference shares are part of share capital. The
convertible will have a stated annual interest payment. (1)

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Warrants are call options written by a company on its own stock. The purchaser of a
warrant has the right but not the obligation to buy a fixed number of the company’s shares at
a fixed price at a fixed date. (1)

Floating -rate notes (FRNs) are medium-term debt securities issued in the Euro market
whose interest payments "float" with short-term interest rates, possibly with a stipulated
minimum rate. (1)
[Total 6]

Que 12)

A listing will help to raise capital. If the company is quoted then it will be able to sell shares
to a wide market and raise large sums cheaply. This is because the listing will provide a free
secondary market in the company’s shares.

Providers of debt will lend more happily to a quoted company as they know that the company
must comply with the Stock Exchange requirements on an ongoing basis. Shareholders will
also benefit from the fact that the shares will have a readily observable market price which
may be useful for tax purposes and also for portfolio management. These advantages will
also help the company to raise funds.

The ease with which shares in quoted companies can be traded means that shareholders
have an easy exit route if they ever decide to sell their investment. The fact that they can do
so means that they will feel far more secure when buying shares.

The ready availability of a market price means that the shares are far more acceptable to
employees if they are granted as part of a share option scheme. It will be possible to attribute
a value to the shares or options received. The fact that the shares are listed will also make
them more readily available to use as the purchase consideration in a takeover situation.
Shareholders of the target company will have a far clearer impression of the relative values
of the shares being offered compared with the ones that they already hold.
[Total 8]

Que 13)

The manager should consider the current level of gearing. If the company is already heavily
financed by debt then it will be difficult for him to justify borrowing more.

The use of one form of finance can have implications for the risks, and therefore costs,
associated with the other. Issuing fresh debt will expose the existing shareholders to a greater
risk of losing their investment if the company is forced to default on its loans. This will mean
that the cost of equity might increase. Issuing fresh equity creates a broader “buffer”

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between assets and liabilities for providing lenders with collateral and that might reduce the
cost of debt.

Debt finance is usually cheaper than equity and so the company should consider using it
wherever possible. The lower cost is partly because the debt holders are taking much less of a
risk when they purchase debt stock and are, therefore, willing to accept a lower rate of return.

The cost of debt is further reduced because interest is allowable as an expense for tax
purposes, whereas dividends on shares is not. It might be difficult to sell Rs 5,00,000,000 of
share capital without incurring disproportionate issue costs. Raising debt can be rather more
flexible. The company could, however, get round this by issuing rather more than Rs
5,00,000,000 and using the additional sum raised to repay some of its existing debt.

[Total 8]
Que 14)

Many figures in the financial statements are difficult to interpret in isolation. For example, it
means very little to know how much profit a business made without having some
corresponding idea of the amount of capital that had to be invested in order to generate this
income.

Ratios provide a basis for comparing related figures and for identifying issues that ought to
be investigated. Management might, for example, monitor liquidity by calculating the current
ratio and would deal with any deviation from the optimal relationship – usually 2:1.

Trends in ratios can be particularly revealing. For example, a decreasing current ratio is
normally a more worrying sign than a ratio which appears to be low in absolute terms.

Ratios do have a number of drawbacks. For example, they can be distorted by willful
manipulation of the figures (e.g. window dressing or off-balance sheet financing). They can
also omit crucial information such as contingent liability information.

[Total 4]
Que 15)

RBI acts in a supporting role for the various institutions that are active in the short-term
money markets, particularly the discount houses.

The discount houses provide short term finance by borrowing cash surpluses that might be
available for as little as a few days and lending for a slightly longer period.

This difference in maturity between their assets and liabilities can leave them exposed to the
risk of being unable to repay their debts. The risk of default is avoided because RBI will
always provide the discount houses with support whenever they need it. This can take the
following forms:

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1. The Bank will always be prepared to purchase Treasury or local authority bills or bills of
exchange from the discount houses in order to help them through a cash crisis.

2. The Bank will act as a lender of last resort provided the discount houses
deposit bills as security.

3. The discount houses can sell a bill of exchange to the Bank and simultaneously agree to
repurchase it at a later date.
[Total 4]

Que 16)

Investment banks specialise in corporate finance. Their role is largely advisory.

Typically, they will provide advice on the following types of matter:

1. bid or defence strategies in a takeover
2. financial aspects of a merger
3. investment projects
4. raising capital

They may also act as intermediaries in the issue of financial instruments:

1. issuing houses in share issues
2. underwriters of new issues
3. Eurobonds

They also provide fund management services:

1. management of unit trusts, investment trusts and pension funds
2. organisation of the Eurobond market

Occasionally, investment banks provide finance to companies.

[Total 6]

Que 17)

Agency theory, which considers the relationship between a principal and an agent of
that principal, includes issues such as the nat ure of the agency costs, conflicts of interest
(and how to avoid them) and how agents may be motivated and incentivised.

There are many groups of stakeholders in an organisation, each with its own objectives.
These objectives may conflict. This causes problems when one group is responsible for
taking decisions on behalf of others. The directors of a company make strategic decisions on
behalf of its shareholders, whilst delegating operational decisions to managers. This
separation of ownership and management can lead to principal-agent problems and agency
costs if the interests of the owners and managers diverge.

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Conflicts of interest may also arise between other stakeholders in a business, notably between
lenders and the providers of equity capital, and may be reinforced by information
asymmetries. Agency theory considers 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.

Such conflicts are referred to as principal-agent problems, and give rise to agency costs.
These include the costs associated with monitoring the actions of others, and seeking to
influence their actions.

In practice, the agency costs incurred by the shareholders are usually defined as the sum of
three different component costs, namely:
1. those incurred in monitoring the managers
2. those incurred in seeking to influence the actions of managers
3. those incurred because the managers do not act in the owners’ best interests.

There are two factors that encourage managers to operate in the interests of the shareholders:
job security and remuneration packages. Managers do not want to lose their jobs, nor their
reputations. Many managers receive bonuses based on the company’s earnings or the share
price.

If the shareholders feel that the company is underperforming, they can elect a new board of
directors, which, in turn, will probably appoint a new management team. Alternatively,
shareholders might express their disapproval by selling their shares. If sufficient shareholders
do this, then the share price falls. If the company is underperforming and the share price falls,
the company is vulnerable to a take-over bid. The management team is likely to be replaced
by one that will do what is necessary to maximise shareholder value.
[Total 4]
Que 18)

a)
Cost Saving = 5,000 * 20 * {1/1.1 + 1.09/1.1^2 + …. + 1.09^3/1.1^4 }

= 5,000 * 20 * 1/1.1 * {1 + (1.09/1.1) + … + (1.09/1.1)^3}

= 5,000 * 20 * v 10% * s4 1%

[assuming 1/(1+j) = 1 / (1.10/1.09)) implies j = 0.91% ~ 1% (approx); s4 above has been

taken from tables using 1%; exact calculation using 0.91% will also get full marks]

= 5,000 * 20 * .9091 * 4.06

= 369,090.91

Please note that the exact answer (no approximation) would be Rs 358,708.

Cost that will be incurred = 331,210 < cost savings and hence go for it.

(4)

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b)
The discount rate should be real rate of discount.

Since the cashflows are real these should be discounted at real interest rate. In the current
situation the real interest rate is

= 1.10/1.15 – 1 = -4.3478%
Please note that the first year end cashflow has not been converted to real and other cashflow
also have been converted in a wrong way.
The revised calculations are given below:

year Real Expected Discounted value of real PV of

Cashflows cashflows cashflows
1 100,000 * 1.15 -1 86,957 * 0.956522 -1 90,909
2 109,000 * 1.15 -2 82,420 * 0.956522 -2 90,083
3 118,810 * 1.15 -3 78,120 * 0.956522 -3 89,264
4 129,503 * 1.15 -4 74,044 * 0.956522 -4 88,452
Total 358,708

Which leads to the correct decision i.e. NPV= 358,708-331,210 >0.

{which is equal to answer to part a) except for the approximation assumed in solving part a)}
(5)
c)

Surely the IRR lies between 10% and 15%. Since NPV at 10% is 27452 (from part b) where
as at 15% is -9,671 (from part b).

Using linear interpolation we get 13.70% for NPV to be zero. The formula for the same is
10% + (15%-10%)/(-9,671-27,452)*(0-27,452).

Since this is a convex function the actual value would be less than the above estimated value.
Using the estimate of 13.50% we get NPV =802.

Therefore the estimate lies between 13.5 and 13.70. Since at 13.70% the NPV will be
negative and at 13.50% it is positive and we want an accuracy of 1/10th of decimal, the IRR
is 13.6%.
(4)

d)

Advantages of using IRR for project eva luation:

1) It is simple to understand and easy to communicate.
2) Often easy to compare against cost of capital and interest rates in the economy.

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Disadvantages of using IRR

1) For projects with multiple negative cashflows there may be multiple or not a single
IRR.
2) It ignores the scale of the project. Thus a small project with a high IRR but lower
value may be accepted ahead of an alternative larger project with a lower IRR but a
higher value.
3) Total IRR of all projects together is not just a weighted sum of individual IRRs and
similarly the average IRR across scenarios is not just average of all scenario IRRs.
(4)
[Total 17]

Que 19)

New India Insurance Co. Ltd.

Fire Revenue account for the year ended 31st March , 2005

Expense

Particula rs Amount
Claims under policies
less recovered from reinsurance 637,696
Add: out at the end of the year 104,000 741,696
Commission on direct business 299,777
commission on reinsurance accepted 60,038
Expenses on fire account 375,947
Profit transferred to P & L account 1,053,963
Reserve for unexpired risk 40% of net premium 1,035,603

3,567,024
Revenue

Particulars Amount
Balance of account at the beginning of the year:
Reserve for unexpired reserve 930,000
Premium less re- insurance 2,589,008
Commission on re- insurance ceded 48,016

3,567,024

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Profit and loss account for the year ended 31st March , 2005

Rents 67,500
Rates and taxes 5,804
Audit fees 36,000
Provision for taxes 439,063.6
Transfer to general reserve 200,000
Balance c/d 533,595.4

1,281,963

Balance b/d 75,000

Profit transferred from revenue account 1,053,963
Income from investments 153,000

1,281,963

Balance Sheet as on 31 st March 2005

Liabilities Amount
Share capital 900,000
General resesrve 45,000
additions during the year 200,000 245,000
Profit and loss account 533,595.4
Fire revenue account 1,035,603
Other liabilities
Claims intimated but not paid 104,000
Provision for taxation 439,063.6
sundry creditors 22,500 565,563.6

3,279,762

Assets Amount
Investments 3,075,000
Outstanding premium 22,300
Cash and bank balances 182,462

3,279,762

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Notes:
1) Claims paid 602,815
+ Survey fees & legal charges 56,000
+ Recovered from re- insures 21,119 637,696

2) Expenses of management 431,947

- survey and legal fees 56,000 375,947

3) Premium 2,701,533
- reinsurance 112,525 2,589,008

3.2)Reserve for unexpired risk:

40 % of net premium 1,035,603

4) Provision for taxation

+ Profit from revenue account 1,053,963
+ Income from investments 153,000
1,206,963
- Rent 67,500
- Rates and taxes 5,804
- Audit fees 36,000
109,304 1,097,659
Provision for taxes @ 40 % 439,063.6

[Total 23]

*********************

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 Actuarial Society of India

EXAMINATIONS
June 2005

CT2 – Finance and Financial Reporting

Indicative Solution

S-CT2 Page 1 of 12
1 A
2 C
3 C
4 A
5 D
6 B
7 B
8 D
9 C
10 C

11

Toll revenues

Use the midpoints of each range, so that the expected toll revenue if the bridge is a success is 45 in
each of year 3 to 5, whereas if it is a failure, the revenue is 25 in each of these years.

Weather

In the case of good weather, the cost in year 2 is zero . In the case of bad weather, the cost in year
two is 20 (assuming no strikes).

Strikes

If there are no strikes, the costs are as noted under weather. If there are strikes, then the costs are
increased to 60 in year 1, and either 0 (good weather) or 24 (bad weather) in year 2.

An outcome or state of world is denoted by a string of three numbers, and the probabilities, cash
flows and NPVs associated with each possible state of the world are summarized in the table
below.
Probabilities Cash flows in each year State of the NPV @ 10%
world
1/6 -50,0,45,45,45 A1,B1,C1 51.74

1/4 -50,-20,45,45,45 A1,B2,C1 33.55

1/6 -60,0,45,45,45 A1,B1,C2 41.73

1/12 -60,-24,45,45,45 A1,B2,C2 19.92

1/12 -50,0,25,25, 25 A2,B1,C1 6.52
1/8 -50,-20,25,25,25 A2,B2,C1 -11.66
1/12 -60,-0,25,25,25 A2,B1,C2 -3.48

S-CT2 Page 2 of 12
 1/24 -60,-24,25,25,25 A2,B2,C2 -25.30

[1/2 mark for each correct NPV {1/2 x 8 = 4}, 1/4 mark for each correct probability {1/4 x 8 = 2}]
[1/2 mark for identifying that there are 8 possible states of the world, 1/2 for taking mid values]
{Total till now = 4+2+½ + ½ =7 marks}

Thus the Expected NPV is given by:

1/6*51.74+1/4*33.55+….1/24*-25.30 = 23.4
[1 mark]
{Total till now = 7 +1 = 8 marks}

Note: A1 = Success
A2 = Failure
B1 = good weather
B2 = bad weather
C1 = no strike
C2 = strike

Comments: {maximum 3 marks}

The expected NPV is positive, suggesting that the project should be undertaken (all else being
equal) [1 mark]

The actual NPV is positive with a probability of 3/4. [1/2 mark]

The most critical of the three risk facing the project is that of low tolls, which has the greatest
impact upon the expected NPV and hence the success of the project. The difference between the
expected NPVs with low and high tolls is equal to 45.2. [1 mark even if the difference is not
mentioned in figures]

The NPV is always positive if the toll revenue is high (equal to 45) [1/2 mark]

Bad weather is probably the most important risk, as two of the three negative results- the two worst
results in fact- arise when the weather is bad. In fact, bad weather reduces the expected NPV by an
amount equal to either 18 or 22. Conversely, a strike reduces the expected NPV by either 10 or
about 13.6. [1 mark even if figures are not reported or even if strike is not mentioned.
Conversely, if only strike is mentioned without weather being mentioned and it is identified as
third important factor then ½ mark.]

S-CT2 Page 3 of 12
12

Strategies that could be considered

1. No dividend over the period of the restructuring. This might be appropriate if the problems
are at the core of the business and there is no guarantee that former levels can be attained
again in the future.
2. Continue paying the dividend at the former level in the anticipation that profits will recover
to this level again. If the management is confident that the current problems are short lived
and not core to business, then this could be the optimal choice.
3. Pay a scrip dividend rather than a cash dividend. If cash flow is a problem, but the level of
dividend can be justified at its former level, then this would be a solution.
[1 mark for each strategy which would be split as ½ for the strategy and ½ for the rationale.]

13

The manipulation may involve inflating current operating income (via an increase in booked sales
or a decrease in expenses) or reducing current operating income (in order to increase future
earnings). The later may be encouraged by the use of the executive incentives linked to future
performance. [1 mark for identifying that manipulation may be to increase current or future
profits]

Accounting practices that can lead to such misstatements include:

1. Inappropriate depreciation of tangible assets.

There are various choices available like written down value or straight line method and also
the rate of depreciation to be used. High depreciation would boost future earnings and vice
versa.

2. Inappropriate amortization of intangible assets.

This is similar to depreciation of tangible assets.

3. Inappropriate valuation of stocks & inventories.

Stocks and inventories may be valued using LIFO, FIFO, Average Stock Method, etc.
Depending on the inflation environment, the choice of method would either increase or
decrease the current profit.

4. Inappropriate valuation of future liabilities.

Future liabilities may be valued either very conservatively or optimistically impacting the
current profits. This is more important for companies having long term liabilities like life
insurance companies.

5. Unwarranted revaluation of tangible assets.

Revaluation of existing assets may be carried out to reflect the market boom/recession so
that current period profit is increased / decreased.

6. Creating intangible assets of questionable true worth.

S-CT2 Page 4 of 12
 Intangible assets may be created with high/low value which may increase/decrease the
profits.

7. Omitting contingent liabilities.

Contingent liabilities may need to be valued and by omitting/ decreasing/ increasing such
liabilities the company may increase/decrease the current period profits.

8. “pre booking “ of anticipated sales value.

Pre-booking of sales would inflate the current period revenue and hence profits.

[Maximum marks 6 for this part.]

[1 mark for each of the point. Give marks for maximum of 6 points.]
[The 1 mark would be split as ¼ for the heading and ¾ for the explanation]

14

Agency theory considers the relationship between a principal and an agent of that principal and
includes issues such as the nature of the agency costs, conflict of interest (and how to avoid them)
and how agents may be motivated and incentivised. [2 marks:- no part marking in this portion]

Example: The relationship between the shareholders and the management. The shareholders are
the principal who theoretically own the company. It is possible that there may be large number of
shareholders each holding a very small stake. Under such a situation, usually the company would
be managed by professional managers who may not be the shareholders of the company or even if
they own shares, the holding would be very small. They would not be running the company as
owners as they would not own large portion of shares. In such a situation, it is possible that they
may try to increase their salary and other perks as this would go to them directly rather than
increasing the profit of the company, which would be shared with large number of other
shareholders. This gives rise to the conflict of interest. The management may take actions which
would benefit them more than the shareholders. [1.5 marks - Any other suitable example may also
be considered.]

Divergence of interests leads to the possibility of conflicts of interests. So the solution may relate
to motivating the managers to take decisions in the interest of the shareholders. There are two
factors that encourage managers to operate in the interests of the shareholders: job security and
remuneration packages. Firing of management for bad performance may be one solution. Effective
implementation of this option would depend on effectiveness in communication of performance
goals. Another solution may be to provide a proportion of salary / perks in the form of stock
options. The value of call option would be positively related to the share price which in turn, will
be related to the firm's performance. So to maximise their wealth, the management may act in the
interest of shareholders, as share price maximization would lead to increase in their personal
wealth. [1.5 marks]

S-CT2 Page 5 of 12
15.

Profit & Loss Account for the year ended 31 March 2005

Rs. 000 Rs. 000

Sales 1175
Closing stock 8
Cost of sales:
Opening stock 6
Purchases 502
Depreciation :
Building 91
Plant & Machinery 132
Salary 112
Rent & rates 100 (943)
Gross profit 240
Expenses:
Administrative expenses 45 (45)
Operating profit 195
Interest (65)
Net profit before tax 130
Tax (26)
Net profit after tax 104
Dividends (17)
Retained profit 87
Profit & loss brought forward 160
Profit & loss carried forward 247

[Total max. 5 marks.

3 marks for correct answer up to operating profit otherwise 0;
2 marks for correct answer of profit & loss carried forward otherwise no marks;
no part marking ( either 5 or 3 or 2 or 0 ) ]

Balance Sheet as at 31st March 2005

Rs. 000 Rs. 000

Fixed Assets
Land & Building- cost 1300
Plant & Machinery-cost 800
Depreciation (558) 1542
Current Assets
Cash 12
Stock 8
Debtors 245 265

S-CT2 Page 6 of 12
Current Liabilities
Creditors 187
Tax provisions 26
Dividend payable 17 (230)
Net current assets 35
Long term liabilities
Loan (450)
Total assets Less outsiders liabilities 1127
Share capital and reserves:

Share capital 700

Share premium 180
Profit & Loss 247 1127

[Total max. 5 marks.

1 marks for total correct fixed assets figure,
1 for total correct current assets,
1 mark for total current liabilities,
2 mark for total of both sides of balance sheets matches with the answer.]

Notes:

1) building depreciation: 20% (555-100)=91

2) Plant & Machinery Dep : 20% (800-140)=132
3) Total depreciation = 195+140+91+132

[ ½ mark for the calculation of dep. on building and ½ mark for the calculation of dep. on plant &
machinery.]

[1 mark for the neatness,

2 mark for the correct format of P.& L. A/C and Balance Sheet]

16

The accounting concepts are:

1. The cost concept (historical cost)
2. The money measurement concept
3. The business entity concept
4. The realization concept
5. The accrual concept
6. The dual aspect concept
7. The materiality concept
8. The prudence concept
9. The going concern concept
10. Consistency concept

S-CT2 Page 7 of 12
[Maximum 2 marks for listing with ¼ mark for each point above ]

[No marks for description given for point number 1 and 7]

[1 mark for each description and maximum 3 marks]

The money measurement concept

Accounting statements can be measured objectively in money terms. It will exclude items like
value of the company’s customer base, its work force, its brand name etc.

The business entity concept

The affairs of the business are kept separate from those of the owners.

The realization concept

Income is recognized as and when it is “earned”. It is not, therefore, necessary to wait until the
customer settles his bill.

The accrual concept

Expenses are recognized as and when they are incurred, regardless of whether or not the amount
has been paid.

The dual aspect concept

This concept recognizes that every transaction will affect two figures. This concept forms the basis
for the double entry book keeping system.

The prudence concept

The preparers of the financial statement should avoid presenting an unduly optimistic set of results.
Prudence should only be applied in situations when there is uncertainty.

The going concern concept

It is assumed that a business will continue indefinitely in its present form.

Consistency concept
The figures published by the company should be comparable from one year to the next.
Accounting policies should not, therefore, be changed from one year to the next unless there is a
very good reason for doing so.

17

Complications of insurance company accounts

The preparation of insurance company accounts is complicated by two special features:

1. The underlying contracts (liabilities) fall due outside the accounting period and are
uncertain in size.

S-CT2 Page 8 of 12
 2. Premature transfer of profits to shareholders may endanger the financial stability of the
company and the ability to meet future liabilities.
[1 for each of the above points = 2 marks]

[Maximum 3 marks for the part given below]

Estimates of the future liabilities have to be made, either on a statistical basis, based on past
experience, or by expert judgment. [1/2]

These estimates are frequently reviewed and updated in the light of claims experience. [1/2]

Premiums already received in respect of such liabilities need to be identified and held until such
time as the liabilities have expired. [1/2]

Insurance companies are likely to adopt a prudent approach to the estimation of their liabilities,
and since theses reserves are entered as a cost in the profit & loss account, their profits are likely to
be understated. [1/2]

This conflicts with the basic principle that the accounts should give a true & fair view of the state
of the company. [1/2]

There is an additional problem caused by the long term nature of the business. New business
initially causes a financial strain due to the cost of setting up the contracts and establishing
adequate initial reserves. However, overtime, the product is designed to make a profit for the
business. The question arises as to when and how this profit should be reported. [1]

The tax system might cause a further problem if particular classes of business are taxed in different
ways. The company might have to set up separate sub funds for tax purpose. [1/2]

18

The basic principles of capital gains tax are given below:

1. Chargeable gains should normally fall into the tax year of assessment, during which the
gain is realized so that the funds to pay the tax should be available. [1 mark]
2. Chargeable gain is typically defined as (sale price – purchase cost). The sale price may be
reduced to reflect any costs associated with the sale. The purchase cost may be increased
by any costs associated with the purchase. [1 mark]
3. Indexation allowance may be provided further to remove the capital gains due to general
inflation and hence to reduce the tax liability. [1 mark]
4. Capital losses may be offset against capital gains in the same year. Any “unused” capital
loss may be carried forward to be offset against capital gains in any future years. [ 1 mark ]
5. The rules for offsetting capital losses do not apply if the loss is only caused by the
indexation allowance. [ 1 mark ]
6. The tax rates may be different for capital gains or may be the marginal tax rate after
clubbing the resulting gain with the total income. The tax rate method may be different for
individual and corporate. [ 1 mark ]

S-CT2 Page 9 of 12
[Maximum 5 marks ]

19 i)

An interest rate swap would be the most appropriate form of derivative. [1 mark]

The company will agree to pay to a second party, a regular series of fixed amounts for the five year
period. In exchange, the company would receive from the second party a series of variable
amounts based on the level of a short term interest rate. This can be used to service the floating
rate loan. [2 mark]
The fixed payment can be thought of as interest payments on a deposit at a fixed rate, while the
variable payments are the interests on the same deposit at a floating rate. The deposit is purely
notional, no exchange of principal takes place. [1 mark]

19 ii)
Buying a put costs money as one has to pay premium. The benefit of buying a put is that it
provides downside protection if the stock price moves down. But, the premium which one has to
pay means that share price should move up more than the premium amount within the expiry time
to make some money. [1 mark]

Since, it is not guaranteed that stock price will move up by that amount, you are not guaranteed to
make money. However, you are guaranteed that the loss will not be more than the premium
amount.
[1 mark]

20

i)

The company has no debt finance, so the WACC is equal to the cost of equity, which is given by:
risk- free return + beta X market risk premium
=6% + 1.2 x 8% = 15.6% [1 mark]

Year 0 ½ 1½ 2½ 3½
Cashflow (30) (5) 4 12 37
PV @ 15.6% -30 -4.6504 3.21828 8.35193 22.2766

NPV = -0.8036 Crore

[2 marks= 1 mark for identifying correct cash-flows with the correct time + 1 mark for correct
NPV computation]

ii)
Advantages of using WACC
• Using the same cost of capital across an entire business leads to fe wer internal problems.

S-CT2 Page 10 of 12
• It is easy and quick.
• It reflects the overall risks in the company’s existing portfolio of projects.

[2 Marks]

Disadvantages of using WACC

• The project may be riskier than other projects in the company’s portfolio. In particular it may
have more systematic risk than the average project. It should be evaluated using an appropriate
return to reflect the higher beta for the project.
• The investor’s expectations will change when this large project is added to the portfolio, thus
the overall WACC will change.

[2 Marks]

iii) IRR (by interpolation)

We have an NPV of -0.80 Cr at 15.6%. Recalculating at 14% gives an NPV of 0.64 Cr. Therefore,

IRR = 14% + 0.64 / (0.64 + 0.80) * 1.6% = 14.71% [1 mark]

Checking this answer: NPV at above rate is -0.01 Crore.

iv)
The company currently has equity shares with a market value of 30 x 105 = 3150 Crore. The
suggested capital structure would leave the company with 1000 Cr of debt and 2150 Crore of
equity.

Debt is clearly perceived as risk free as the interest rate matches with the risk free rate. [1 mark]

To calculate new beta of the ordinary shares we can use:

Geared beta = Un- geared beta X ( 1 + debt/equity X (1-tax rate) )
= 1.2 X ( 1 + 100 / 215 * 0.7 ) = 1.59 [ ½ mark]

The return required by equity shareholders would then be 6% + 1.59 * 8% = 18.73% [½ mark]

Thus the WACC = (1000*6%*0.7+2150*18.73%)/3150 = 14.11% [1 mark]

This is below the IRR for the project. Therefore, the project would have a positive NPV at the new
WACC for the company. This makes the project more viable. [1]

v)
The company could perform any of the following sensitivity tests:
• The effect on the NPV, if the anticipated selling price of each house is reduced by 10% [1]
• The effect on the NPV, if the anticipated raw material cost is increased by 10% [1]

S-CT2 Page 11 of 12
• The effects of a half year delay in all cash- flows, caused by construction problems. [1]

[Maximum 2 marks.
Mark may be awarded for other valid points.]

vi)

Shareholder value analysis

• Analyse what investors appreciate about equity investments in general and the shares of this
company in particular. [½ mark]
• This might be a low PE, a high cash-flow, a low beta, high gearing etc. [½ mark]
• Calculate the current values of these factors and then model the company including the new
project, paying close attention to the effect on the factors that are most important to investors
(and paying less attention to those factors that are deemed not important to investors) [½
mark]
• Adopt or reject the project on the basis of the extent to which it adds shareholder value. [½
mark]

21

The factors that may be considered are:

1) the need for finance and the amount of finance I can contribute
2) the ease of raising finance in the future
3) liability for debts
4) ease of setting up
5) disclosure requirements
6) control of the business
7) roles and responsibilities
8) the type of business

[ ½ for each, maximum 3]

S-CT2 Page 12 of 12
 Actuarial Society of India

Examinations

November 2005

CT2 – Finance and Financial Reporting

Indicative Solutions
 CT2 Nov 05

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

[2 marks each]

Q.11)

a)
Risk Matrix

A risk matrix is a table used for the identification and analysis of the risks inherent in a
capital project.
[0.5]

It provides a systematic method by which to identify and characterize risks and thereby
reduce the chance that any particular risk will be overlooked.
[1]

The main column headings shown relate to the causes of the risk e.g. political, business,
economic etc.
[0.5]

The row headings relate to the different risks that arise in the different stages of the project,
e.g. creation of asset, operation of asset. [0.5]

The risk analysis team considers each cell of the table in turn and identifies the relevant
risks.
[0.5]

The characteristics of the risks thus identified can then be analyzed [0.5]

Theses will normally be assessed according to categories such as likelihood of occurrence,

degree of dependence, controllability and financial impact on the project.
[0.5]

2
CT2 Nov 05

b)

Systematic risk is the element of the variability of the investment return that can be
eliminated neither by investing in the same type of project many times over, nor by investing
in a well diversified portfolio of different projects.
[1]

It stems from factors external to the project in question that effect all projects and assets to
some degree, e.g. the common business cycle.
[0.5]

Probabilistic risk is the element of the variability of investment return that can be eliminated
either by repeated investment in a number of similar project, or failing this, by diversification
over a number of different projects.
[1]

It, therefore, stems from factors that are internal and hence specific to the particular project,
e.g. cost overruns arising from incorrect forecasts or poor management.
[0.5]

As probabilistic risks can be eliminated through diversification, investors should not be

rewarded by any additional expected return for accepting them.
[1]

When appraising a capital project, probabilistic risk should be allowed for by specific risk
analysis, and an explicit adjustments to the cash flows concerned, allowing for both the
upside and downside risk potential.
[1]

Only if this is not possible, perhaps because it is difficult to assess the impact of a particular
probabilistic risk, should adjustment to the risk discount rate used to value the project cash-
flows be considered.
[0.5]

In contrast, the risk discount rate should be adjusted appropriately to reflect the estimated
degree of systematic risk inherent in the project, i.e. higher systematic risk implies a higher
risk discount rate.
[1]

This is because:

- Historical data suggests that investors typically require a higher level of expected
returns, in return for investing in assets with a higher level of systematic risk – given
that they cannot diversify it away.
[1]

3
 CT2 Nov 05

- increasing the discount rate is consistent with the assumption that the risk increases
exponentially with time, as one looks further into the future. Whereas this is unlikely
to be the case for a probabilistic risk that is specific to a particular project, it is a
reasonable assumption as regards systematic risk.
[1]
[Maximum up to 8 marks]

Q.12)

If company H is a holding company and has total ownership of its subsidiary company S,
then company H will have shares in S as part of its fixed assets and the shares of company S
will all be owned by the holding company.
[1]

When preparing consolidated accounts for the group, internal relationship like these are
cancelled out to avoid double counting, and other items of the balance sheet are simply added
together.
[2]

If company H paid more than the book value for the shares of S, when consolidated, the
difference (goodwill) would be recorded as an intangible asset of the group.
[1]

If company H does not own all of the shares S, then the rest of the shareholding is termed as
“minority interest ”.
[1]

On consolidation, when the internal relationships are cancelled out, the minority interest must
appear separately in the balance sheet, at the end , just before the totals.
[1]

Q.13)
Consolidated balance sheet

We must first calculate the goodwill involved in the transaction. This can be calculated by
comparing the value of the shares or cash paid to acquire company Y against the book value
of the assets purchased:

Goodwill = Rs. 4 crore- Rs. 3 crore=Rs 1 crore

[1]

4
 CT2 Nov 05

We can than construct the following consolidated balance sheet:

Company X
Rs. In cr.

Fixed assets 15
Current assets 5
Current liabilities (4)
Long term liabilities (7)
Total 9

Share capital 6
Reserves 3
Total 9

The assets and liabilities of company X and Y have been added.

[1]

After having cancelled out the internal relationship to avoid the double counting of X’s
investment in Y.
[1]

Notes:
- the Rs. 1 crore goodwill has been added to the fixed assets.
[1]

- the total current assets of X and Y is Rs. 9 cr. However, Rs.4 cr of cash has been paid
in respect of the transaction, therefore the remaining current assets would total Rs. 5
cr.
[1]

Q.14)

Depreciation is defined as the measure of the wearing out, consumption or other reduction in
the useful economic life of a fixed asset, whethe r arising from:
[0.5]

- effluxion (passage) of time, or

[0.5]
- obsolescence through technological or market changes.
[0.5]

Depreciation adjustments are required because virtually all fixed assets have finite useful
economic lives. There are two reasons for this:
[0.5]

5
 CT2 Nov 05

- If a company buys an asset which it still owns at the end of the year, the company
has not lost the amount spent. The real loss is the difference between the value of
the asset at the start of the year and the value of the asset at the end of the year.
[1]

- The amount spent on the fixed assets can vary considerably from year to year.
The profit and loss account would not, therefore, give a true picture of a
company’s underlying long term profitability as the expenditure on fixed assets
could distort the profitability from year to year.
- [1]

Q.15)

There are four items in the share capital and reserves:

- Share capital is the nominal value of the shares issued.
[1]

- The share premium account records the additional amount raised from the shares
issue in excess of the nominal value.
[1]

- The revaluation reserve records an increase in the value of fixed assets if fixed
assets are revalued upwards.
[1]
- The profit & loss account records the profit retained in the business to date.
[1]

Q.16)

Advantages:

The major advantage of a limited company is that its limited liability state makes it much
easier for the organization to raise money from investors. Investors may be reluctant to
become involved as a part owner of a partnership , since they risk their entire personal wealth.
With limited liability, investors are likely to be much more willing to provide capital.
[1]

This is particularly important for business ventures involving a risk of incurring substantial
debts (such as insurance companies), and businesses which require large amounts of capital.
[1]

Limited liability allows large number of people to invest small amounts of money with
relatively minimal checking of the company’s prospects. Investors can have shareholdings in
a wide range of companies thus spreading their risk.
[1]

6
 CT2 Nov 05

The board of directors can choose to hire professional managers to run the company. The use
of specialists increases efficiency.
[1]

The separation of owners and managers allows the ownership to change without affecting
management.
[1]

Disadvantages:

The main disadvantage of a limited company is for the creditors of the company following a
winding up. Once the company’s assets have been exhausted, the trade creditors have no way
of ensuring payment.
[1]

Ownership of the business is often divorced from day to day control, which may encourage
an inefficient corporate attitude to develop. The managers of a company may have aims that
are not in the best interests of the shareholders. This is an example of the agency problem.
[1]

Similarly, limited company allows investors to invest in shares without taking an active
interest in the long-term needs of the company, because they may be more interested in short
term gains.
[0.5]

Information asymmetries often exists between various classes of stakeholders i.e. the
different stakeholders have access to different information. This makes any agency problem
more difficult to resolve.
[1]

It also reinforces the need for proper accounting standards to be observed.

[0.5]
[maximum up to 8 marks]

Q.17)

Reasons for seeking a listing:

- to raise capital for the company.
- to make it easier to raise equity finance particularly where the company hopes to
expand
- to make it easier to raise short and long term debt finance, because lenders feel
safer and happier about lending money to a listing company.
- to give existing shareholders an exit route.

7
 CT2 Nov 05

- to enable the company’s shares to be more accurately and easily valued by supply
and demand in the market.
- to enable the shareholders to use the company’s listed shares as backing for their
own borrowings and thus increase the attraction of holding the share
- to enable the xyz company to offer listed shares to shareholders in another
company which the xyz company wants to take over
- to take advantages of temporarily high share prices
- to increase the status of the company.
- to increase public awareness of the company to increase sales.
- to increase the number of shareholders who ow n shares in the company to
improve marketability of the shares.

[ 0.5 mark for each to a maximum of 5 ]

Q.18)

I)

Four shares would have been worth 4*450=Rs. 1800

[0.5]

In theory after the issue, this would leave five shares worth 1800 + (100+250)= Rs. 2150.
[1]
Thus, the shares would be worth 2150 / 5 = Rs. 430 each.
I) [0.5]
II)
The shareholder can take up his rights, or sell them in the market, or just let them to lapse.
[1]

He must take up his rights to protect his stake in the company, assuming that the rights issue
will succeed.
[1]

The larger the discount, more valuable is the right to shareholders.

[1]

The discount actually helps to ensure that the issue proceeds smoothly and without undue
expenses.
[1]

The discount is necessary to avoid the company having to pay substantial underwriting fees.
[1]

8
 CT2 Nov 05

He may sell the rights for their market value for the issue to have no effect on his wealth/
investments.
[1]

If the rights price is close to the market value, even a small fall in the share price could make
the rights irrational to exerc ise.
[1]
[max. 6 marks for this part]

Q.19)

The main limitations can be described under the following sub-headings:

1. Subjectivity
2. Appropriateness
3. Comparison between firms
4. Some limitations of ratio analysis
5. Accuracy of figures
[1]

1. Subjectivity:

Firms use a range of different methods to arrive at the figures to put in their accounts. For
example:
[0.5]

Stock valuation: stocks can be valued in a number of ways, e.g. FIFO or LIFO or any other
method
[0.5]

Depreciation: firms have a large choice as to the depreciation method used. Any method will
at best approximate the true pattern of the reduction in the value of the fixed assets.
[0.5]

Revaluation of assets: some firms revalue their assets when their asset value increase, others
do not.
[0.5]

Intangible assets: These are often particularly hard to value. A great deal of subjectivity is
involved in putting a value on a brand name, for example, many companies don’t even try to
value intangible assets.
[0.5]
[Max 2]

9
CT2 Nov 05

2. Appropriateness of the figures used :

The figures presented in the accounts may not be most appropriate for the purpose of a
particular user of the accounts.
[0.5]

Going concern: The value of many assets would be much lower on a wind- up basis than on
the on- going basis usually assumed.
[0.5]

Present values: The amount shown for debtors and creditors are their face values, not their
true present value.
[0.5]

Accuracy: Giving a “true and fair” view does not mean that accounts are absolutely accurate.
Many items in the accounts will be estimated.
[0.5]
[Max 2]

3. Difference between firms

Many users of accounts wish to compare different firms:

[0.5]

Comparability: Many of the problems above (e.g. stock valuation, depreciation method) are
worrying since different firms use different methods. This makes reliable comparisons
between firms very difficult.
[0.5]

Creative accounting: A few firms may deliberately set out to mislead by choosing the
accounting policies that will maximize reported profits.
[0.5]

Formats: The choice of accounting formats can mean that different firms can produce sets of
accounts which are difficult to compare.
[0.5]
[Max 2]

4. Some limitations of ratio analysis :

Ratio is a very useful technique for the interpretation of financial statements. It does,
however, have its limitations. Some of these are outlined below:
[0.5]

10
CT2 Nov 05

Diverts attention: It diverts attention from the figures and statements themselves. It is
important to look at aspects such as the sheer size of the company unde r consideration. It is
also important to look at the information in the notes which is not usually reflected in the
ratios.
[0.5]

Appropriate comparison?: Comparisons can be affected by different accounting policies or

by other external factors. If, for example, two haulage companies use different methods for
the calculation of depreciation then any ratio based on their financial statements might not be
comparable.
[0.5]

Different industries: There could be peculiarities of the trade which make it difficult to
interpret certain ratios. A property company, say might appear to have a low return on capital
employed.
[0.5]
[Max 2]

5. Accuracy of the figures:

Due to the difference approach adopted by companies, the figures shown in the account may
not always show an accurate picture of the state of affairs.
[0.5]

Out of date: The figures reported will necessarily be out of date by the time they come to be
published and read.
[0.5]

Window dressing: Some firms have been known to delay transactions so that they occur just
after the year end, or to advance other transactions so that they are included in the year end
accounts.
[0.5]

Forecasting: Although they are only meant to serve as a historical record, accounts are
widely used as a means of predicting the future. Interpreting accounts for this purpose is full
of problems. For example, no indication is given of the firm’s plans for the future.
[0.5]
[Max 2]
[Max 2 marks for suitable drafting style and tone ]
[Total Maximum 13 marks]

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 CT2 Nov 05

Q.20)

I)

Analyzing the expected case first.

The cost of the new machine is Rs 10 Crore. The economic life of the new machine is
expected to be 10 years, and so the equivalent annual cost of the new machine is:

10 Crore / 5.650223 = Rs 1.77 Cr (approx)

[2]

The annual savings in costs:

0.5 Crore x (Rs 8 – Rs 4) = Rs 2.00 Cr

[1]

The add itional earnings on the salvage value (which has been freed from the physical
investment in machine) is

0.12 x ( 1 Crore ) = 0.12 Crore

[1]

Thus, the equivalent annual cost savings is:

2.00 +0.12 -1.77 = Rs 0.35 Cr

[1]

Sensitivity Analysis:

Sales (Pessimistic): Annual savings in costs would be 0.4 Cr x (Rs 4) = Rs 1.6 Cr. Therefore,
the equivalent annual cost savings would be reduced to Rs.-0.05 Cr. (=+1.6+.12-1.77) (i.e.
loss)
[1]

Similarly, Sales (Optimistic) would be Rs 1.15 Cr. (=0.7*4-1.77+.12)

[1]

Economic Life (Pessimistic): Expected life of the new machine would be 7 years. So
equivalent annual cost of the new machine would be 10/4.564 = Rs 2.19 Cr. Equivalent
annual savings would be Rs.-0.07 Cr (=2.00-2.19+.12) (i.e. loss)
[1]

Similarly, for Economic Life (Optimistic ) the equivalent annual savings would be 2.00+0.12-
10/6.424 =Rs.0.56 Crore

12
CT2 Nov 05

[1]

Manufacturing Cost (Pessimistic): Equivalent annual savings would be 0.5 x (8-6) +.12– 1.77
= Rs Rs.-0.65 Cr (i.e. loss)
[1]

Similarly, Manufacturing Cost (O ptimistic): 0.5 x (8-3) +.12 – 1.77 = Rs.0.85 Cr.
[1]

Summarizing all the above in a table:

[1]

Equivalent Annual Cost Savings (Crore)

Pessimistic Expected Optimistic

Sales -.05 .35 1.15

Manufacturing -.65 .35 .85
Cost
Economic Life .07 .35 .56

II)

In terms of potential negative outcomes, manufacturing cost is the key variable.

[1]

Goodyear should go ahead with the study, because the cost of the study is considerably less
than the possible annual loss if the pessimistic manufacturing cost estimate is realized.
[1.5]

Of course, it may consider the probability of pessimistic scenario happening while taking
such a decision.
[0.5]

******************

13