November 2002

Indicative Solution with Marking Schedule

Subject 108- Finance and Financial Reporting

Key for S108 with Marking Schedule

1. D
2. C
3. C
4. A
5. C
6. A
7. A
8. B
9. D
10. D
Question 11
Distinguish between
a) An operating lease and a finance lease
b) Invoice discounting and non recourse factoring
c) Bill of exchange and commercial paper

(6 marks)

Answer to Question 11
a) Operating Lease
The owner of the asset (lessor) retains most of the risks associated with the
ownership of the asset. The term of the lease is substantially shorter than the
expected useful life of the asset

(1 mark)

Finance Lease
The lessee takes on most of the risks and rewards of ownership.
The term of the lease is usually close to the expected life of the asset (1 mark)
b) Invoice Discounting
It is a form of short-term finance from the suppliers standpoint. Under
this arrangement the supplier sells on its trade debts to a factor to obtain cash
payment of the accounts before their actual due date.

(1/2 mark)

The supplier keeps the responsibility for collecting the debts and the credit
risk remains with the supplier. It is also known as Recourse Factoring.
(1/2 mark)

November 2002
Indicative Solution with Marking Schedule
Subject 108- Finance and Financial Reporting
Non-Recourse Factoring
It is also a form of short-term finance from the suppliers standpoint.
Like invoice discounting the supplier sells on its trade debts to a factor to
obtain cash payments of the accounts before their due date. (1/2 mark)
Unlike invoice discounting, the factor takes over all responsibility for
credit analysis of new accounts, collection of the debts and credit losses.
(1/2 mark)
c) Bill of Exchange
It is a form of short-term finance for a company. It originates when a
company issues a bill to one of its customers. If the customer accepts
the bill and it is guaranteed by a merchant bank, the issuing company
can sell the bill to discount house for cash, rather than having to wait for
the acceptor to pay up.

(1/2 mark)

It is referred to as a two-name instrument because it carries the name of

the company, which owes the money, and of the accepting bank.
(1/2 mark)
It can be issued by any company
Commercial Paper
It is a form of short-term borrowing used by large companies. It is a
bearer document for large denominations, which are issued at a discount
and redeemed at par.

(1/2 mark)

Since it is not guaranteed by bank, it is a single name instrument

carrying the name of only the issuing company. It can only be issued by
large quoted companies that meet certain requirements

(1/2 mark)

(Total : 6 marks)

Question 12
Briefly explain the term double taxation relief.
Answer to Question 12
DTR allows overseas tax paid in countries for which double taxation
agreements exist to be offset against liability to domestic tax

(1 mark)

DTR applies to both companies and individuals with overseas income

(1/2 mark)

November 2002
Indicative Solution with Marking Schedule
Subject 108- Finance and Financial Reporting
The credit is equal to the lower of the foreign tax paid and the domestic
tax due

(1/2 mark)

DTR (typically) doesnt apply to overseas revenues of a capital nature

(1/2 mark)
(Max : 2 marks)
Note: DTR denotes double taxation relief.
Question 13
Some investors have shied away from equity investments on the ground that
Equity shares are the most risky form of investment; so a prudent investor should avoid
investing in them. Comment on this viewpoint
Answer to Question 13
It is true that ordinary shares are potentially risky in that the return from
them can be very volatile (and uncertain)

(1/2 mark)

However an investor would expect, on average, to gain a higher return

from equity investment than from other investments to compensate for the
higher level of risk

(1/2 mark)

In the long term, dividends and share prices should increase in line with
inflation and real economic growth.

Therefore shares are a suitable

investment for an institutional investor who requires a return linked to

inflation

(1 mark)

Also, holding a diversified portfolio of shares can help to reduce

(unsystematic) risk.

(1 mark)
(Total : 3 marks)

Questions 14
From the standpoint of an issuing company, briefly discuss the advantages and
disadvantages of raising debt capital by issuing secured redeemable debentures to public
(5 marks)
Answer to Question 14
From the standpoint of the issuer the advantages and disadvantages of issuing
secured redeemable debentures are as follows:
Advantages:
Interest on debt is a taxable deductible expense whereas equity and
preference dividend are paid out of profit after tax

(1/2 mark)

November 2002
Indicative Solution with Marking Schedule
Subject 108- Finance and Financial Reporting
Debenture financing does not result in dilution of control because
debenture holders are not entitled to vote

(1 mark)

Debenture holders do not partake in the value created by the company as

payments to them are limited to interest and principal

(1/2 mark)

Issue costs of debentures are significantly lower than those on equity and
preference capital

(1/2 mark)

Burden of servicing debentures is generally fixed in nominal terms.

Hence debentures provide protection against high unanticipated inflation
(1/2 mark)
Disadvantages
Debenture financing entails fixed interest and principal repayment
obligations. Failure to meet these commitments can cause a great deal of
financial embarrassment and even lead to bankruptcy

(1 mark)

Debenture financing increases financial leverage which, according to

CAPM, raises the cost of equity to the firm

(1 mark)

Debenture contracts have restrictive covenants, which limit the issuing

companys financial and operating flexibility.

These restrictions can

impair the companys ability to resort to value maximizing behavior.

(1/2 mark)
If the rate of inflation turns out to be unexpectedly low, the real cost of
debt will be greater than expected

(1/2 mark)
(Total: Max of 5 marks)

Question 15
During the current financial year a manufacturing company is considering a scrip
(bonus issue of shares) for its shareholders. Discuss the effects on its financials due to
the scrip issue as against cash dividends for the year

(5 marks)

Ans wer to Question 15

Scrip issue
new shares are created without raising new money
saves cash outflow on account of dividend payment in that year, but results in
additional cost associated with the scrip issue
the retention increases shareholder fund, increases NAV and reduces gearing
additional shares reduces the share price, may dilute EPS
new shares created increases the cost of dividend over the future
(1 mark for each point, maximum marks 5)

November 2002
Indicative Solution with Marking Schedule
Subject 108- Finance and Financial Reporting
Question 16
What are derivatives?

List the main forms of derivative instruments and their

uses for a non- financial company

(5 marks)

Answer to Question 16

Derivatives
Derivatives are financial instruments with value dependent on the value of some other
underlying asset.
Main forms of derivatives are Forward, Futures, Options and Swaps
For a non- financial company they are mainly useful in Currency risk management,
Interest risk management and Borrowing cost management.
(2 marks for each point, maximum marks 5)
Question 17
A company must choose between two mutually exclusive investment projects A
and B. Project A has a higher net present value (NPV) than project B, but project B has a
higher internal rate of return (IRR) than Project A. Explain which of the two measures
(NPV or IRR) is more reliable in the above case and explain whether the company should
choose project A or B.
(6 marks)
Answer to Question 17
A projects internal rate of return can be very misleading. It ignores the size of
the project:
the initial investment could be small;
the investment could be short- lived; or
there could be large positive cash flows in the early years of the project.
(2 marks)
It is not necessarily desirable to receive a high rate of return from a small investment if it
doing so means foregoing an opportunity to generate a larger absolute increase in wealth
from another project.
(1 mark)
The fundamental objective of business is to increase shareholder NPV. That suggests that
NPV is the most reliable measure of a projects worth because it is automatically
consistent with the needs of the shareholders.
(2 marks)
Accepting a project with a positive net present value increases the shareholders wealth
by the NPV of the project.
(1 mark)
The company should choose project A.
(1 mark)
(maximum marks 6)

Question 18
Explain how goodwill can arise on consolidation and how it would be treated in
the accounts of the consolidated company.

(5 marks)

November 2002
Indicative Solution with Marking Schedule
Subject 108- Finance and Financial Reporting
Answer to Question 18

Goodwill
Goodwill arises when the value paid for a subsidiary is greater than the value of the
share of assets purchased.
This is likely to occur because the book value of the assets will not reflect the value
of the company as a going concern.
Goodwill is shown in the balance sheet as an intangible fixed asset in the consolidated
financial statements.
It does not appear in the statements of any of the individual companies in the group.
Goodwill does not have an infinite useful life. It can either be written off over its
useful life or written off immediately to reserves.
[1 mark for each point, maximum marks 5]
Question 19
Given below is an extract from the financial statements of Company X and Company Y.

Company X Ltd

(Rs in lakh)

Fixed assets
Net current assets

480
120
600

Ordinary shares of Rs 10
Reserves
Preference shares of Rs 200

450
100
50
600

Company Y Ltd

(Rs in lakh)

Fixed assets
Net current assets

240
190
430

Ordinary shares of Rs 10
Reserves
Unsecured loan stocks of Rs 100

60
250
120
430

Market values indicate a 400% premium for Xs share, 250% premium for Ys share, par
value for the preference share, and 10% discount for the unsecured loan stock.
Company X takes over company Y. The terms of offer are: 3 ordinary shares in X + 2
preference shares in X + Rs 90 cash, for every 9 shares of Y.

November 2002
Indicative Solution with Marking Schedule
Subject 108- Finance and Financial Reporting
Prepare the consolidated balance sheet clearly showing your workings.

(10 marks)

Answer to Question 19

Consolidated balance sheet of XY Ltd

Goodwill
Fixed assets
Net current assets

1
2
3

Ordinary shares of Rs 10
Reserves
Preference shares of Rs 200
Unsecured loan stocks of Rs 100

4
5
6

(Rs in lakh)
117
720
250
1,087
500
150
317
120
1,087
(4 marks)

Note 1
Goodwill = Purchase consideration NAV of Y
NAV of Y = 60 + 250 = Rs 310 L

(1 mark)

Number of shares in Y = 60 L /10 = 6 L

Value of Xs share = (1+4) x 10 = Rs 50
Value of Xs preference share = Rs 200
Purchase consideration = (3 x 50 + 2 x 200 + 90) x 6 L /9 = 427 L
Goodwill = 427 310 = Rs 117 L

(1 mark)

Note 2
Fixed assets = 480 + 240 = Rs 720 L
Note 3
Cash paid out = 90 x 6 L /9 = Rs 60 L (ignoring expenses)
Net current assets = 120 + 190 - 60 = Rs 250 L

(1 mark)
(1 mark)

Note 4
Number of new shares = 3 x 6 L /9 = 2 L
Total share capital = 480 + 10 x 2 = 500 L

(1 mark)

Note 5
Balancing item
Note 6
Number of new preference shares = 2 x 6 L /9 = 1.33 L
Total preference share capital = 50 + 200 x 1.33 = Rs 317 L

(1 mark)
[maximum marks 10]

November 2002
Indicative Solution with Marking Schedule
Subject 108- Finance and Financial Reporting
Question 20
Explain the limitations of financial ratio analysis in the interprepation of the
financial statements of a manufacturing company

(10 marks)

Answer to Question 20
Ratio analysis diverts attention from the figures and statements themselves. Aspects like
size of the company are very important. For example, a larger company would enjoy
bargaining power and economies of scale, which are not quantified in the ratios.
(2 marks)
Notes to the accounts would reveal critical information that would not be apparent in
ratio analysis. For example, potential litigations facing the company.
(2 marks)
Comparison can be affected by different accounting policies or by other external factors.
For example different depreciation methods or exposure to different currencies can affect
the ratios differently.
(2 marks)
Comparison across different industries would be distorted by different characteristics of
the industries. For example, PER, ROCE etc are typically different for different
industries.

(2 marks)

Financial statements and hence the ratios can be deliberately distorted by creative
accounting or window-dressing. For example, managing the timing of transactions or
choosing biased assumptions.
(2 marks)
Any other relevant points.

(1 marks)
(maximum marks 10)

Question 21
The Board of Directors of K2 Technologies is evaluating the quantum of equity
dividend to be declared for the accounting year ended March 31, 2002. The following
financial information is available about the company
Year Ended 31 March (figures in Rs. lakhs)

2000

2001

2002

Profit after Tax

1500

3300

1200

Equity Dividend Declared

1200

1500

Number of outstanding shares (in lakhs)

300

333

350

November 2002
Indicative Solution with Marking Schedule
Subject 108- Finance and Financial Reporting
(a) Calculate the dividend per share and dividend cover for the years ended 31
March 2000 and 2001; and comment on these values. Can the company
maintain the level of dividend that was declared in 2001?

(4 marks)

(b) Briefly discuss the factors that must be taken into account when deciding upon
the dividend per share announcement for the year ended March 2002.
(6 marks)
(Total 10 Marks)
Answer to Question 21
(a) Dividend per share for YE 31 March 2000
= 1200/300 = Rs. 4.00

(1/2 mark)

Dividend per share for YE 31 March 2001

= 1500/333 = Rs. 4.50

(1/2 mark)

Dividend cover for the

YE 31 March 2000:

YE 31 March 2001

1500/1200 = 1.25

(1/2 mark)

3300/1500 = 2.20

(1/2 mark)

The post tax profits have been volatile over the period but the dividend has been
relatively stable over the two years we have information about.

(1 mark)

If the company wants to maintain the level of dividend that was declared in 2001,
the total dividend outgo for the year 2002 will be 350 x 4.50 = Rs. 1575 million. The
companys post tax profit for the year is not adequate to cover this dividend outgo. The
company will have to dip into the accumulated free reserves if it wants to maintain the
level of dividend that was declared in 2001.

(1 mark)

b) Factors to be taken into account

Can the company afford to maintain the dividend?

It must have

adequate free (distributable) reserves to pay the difference between

what it has earned and what it needs to pay.
What do the shareholders want? Do they buy the companys shares
because they want a stable income flow? If so, the company should
consider maintaining the dividend level if it all possible.
What is the long-term sustainable level of dividend payment, which
the company can afford?
What level of dividend cover should it target?

November 2002
Indicative Solution with Marking Schedule
Subject 108- Finance and Financial Reporting
What do other companies in the sector pay both in terms of dividend
per share and in terms of dividend cover?
What will be the signaling effect of a cut in dividend on the market
price of the share? Is this a relevant consideration at the present time?
How much of the annual profits need to be retained for further
investment? If the company anticipates a large requirement of cash for
investment purposes then it should consider a lower payout ratio
(which implies a higher dividend cover) so that it retains more cash.
If the company anticipates the cash flow and the profits to be under
pressure only for a short period of time, then it should probably
consider maintaining the dividend at a constant affordable level.
Any other sensible factor
(Maximum 6 marks for any 6 sensible factors)
Question 22
You have been approached (in your role as a financial consultant) by Transit
Engineering a medium sized company manufacturing cutting tools to review its
financial position and performance. The companys credit rating has fallen recently
because of fears that it has borrowed too much and that it may not be generating
sufficient cash from its operations to survive the next twelve months. You have been
provided with a copy of the most recent balance sheet, profit and loss account and the
cash flow statement for the past twelve months.
a) List and define three key ratios you would calculate using the balance sheet
and profit and loss account. Briefly explain the reasons for calculating these
ratios.

(6 marks)

b) Briefly explain how you would use the cash flow statement in your analysis
(4 marks)
c) If you reach the conclusion that the company is having an acute cash flow
problem (and it might not survive the next 12 months) list the steps you would
recommend for improving the situation.

(3 marks)
(Total 13 marks)

Answer to Question 22
a) Three Key Ratios based on balance sheet and profit and loss account
i) Current Ratio = Current Assets/Current Liabilities

(1 mark)

November 2002
Indicative Solution with Marking Schedule
Subject 108- Finance and Financial Reporting
This ratio indicates the availability of current assets such as receivables
(debtors), stocks (inventory) and cash in relation to short-term liabilities such
as sundry creditors, bills payable, short-term loans, tax liability and dividends
payable. If this ratio is less than 1, then this indicates that the company may
have difficulties meeting its short-term commitments without realizing
(selling) some long-term assets.

(1 mark)

(Note: Quick ratio or Acid Test Ratio defined as

Current Assets Stocks/ Current Liabilities
would be an acceptable alternative to current ratio)
ii) Asset cover = (Total assets Current Liabilities intangibles)/long term debt
(1 mark)
This ratio shows how all the outstanding long terms loans of the company are
covered by the available assets of the company. This ratio excludes those
assets that cannot be readily realized in the event that the company goes into
liquidation such as intangibles. A ratio of 2 or more would be considered
acceptable

(1 mark)

(Note: The long-term debt to equity ratio will be an acceptable alternative to

asset cover)
iii) Income Cover (or Interest Coverage Ratio)
= Profit before interest and taxation/Annual interest payment on debt
(1 mark)
(Total 6 marks)
b) Usefulness of Cash Flow Statement
A cash flow statement shows how the cash generated in a period has
been used; and how any shortage of cash has been remedied by sale of
fixed assets or by borrowing. It would be useful to see whether the
company had to sell assets or increase the borrowing in order to
generate sufficient cash to fund its operations.

(1 mark)

Profit and Loss account doesnt consider all types of cash expenditure
for example the expenditure on acquisition of intangible assets such
as patents, brands, etc could have been capitalized or treated as
deferred revenue expenditure.

(1 mark)

November 2002
Indicative Solution with Marking Schedule
Subject 108- Finance and Financial Reporting
A profit and loss account shows only the accounting profit, which can
be affected by accounting policies. It may take into account certain
non cash profits such as foreign currency translation gains (1 mark)
A profit and loss account is affected by depreciation, which is a non
cash item, rather than the actual spending on the assets

(1 mark)

It is harder to be creative with a cash flow statement because it is not

affected by the accounting policies

( 1 mark)
(maximum 4 marks)

iii) Suggested Improvements:

If the business is characterized by strong fundamentals over the long
term and the cash crunch is a short-term problem, then the company
can contemplate raising additional equity. The equity raised can be
used to pay off some outstanding debt and reduce the debt burden.
(1 mark)
If the company is not generating cash because of inept working capital
management, then the focus must be on improving the same e.g.: tone
up the collection efficiency; introduce modern methods of inventory
control, etc

(1 mark)

If the company is requiring cash because of expansion the company

can contemplate an equity issue to finance its expansion program
(1 mark)
If the company is likely to be long term insolvent because the business
has ceased to ge nerate cash profits, it might be better to liquidate the
company or explore possibilities of merger/takeover
(1 mark)
(maximum 3 marks)

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