CB1 MOCK SOLUTIONS ACTUATORS EDUCATIONAL INSTITUTE

MOCK 1
CB1
SOLUTIONS
ANSWERS TO MULTIPLE-CHOICE QUESTIONS
The following table gives a summary of the answers to the multiple-choice questions. The answers are repeated
below with explanations.

Q. Ans. Q. Ans.

1. C 2. D

3. A 4. B

5. B 6. C

7. D 8. D

9. A 10. A

SOLUTION 1.
C. A right issue will typically be at a discount to the current market price. There is no legal constraint on the
maximum issue price, but investors that want to buy shares have the option of buying them in the open mar-
ket and so, in practice, the issue price will be less than the current market price.
The par value of a share is the minimum price at which a rights issue can occur. However, it is usual for the
issue price to be at a premium to the par value. Other than the par value imposing a minimum, the issue
price is set by reference to the market price rather than the par value.

SOLUTION 2.
D. A currency swap is typically priced so that the present value of the purchaser‟s net cashflows at outset is
slightly negative. This amount reflects the value to the purchaser of the advantages offered by the swap, eg
the advantage of hedging liability cashflows. It also reflects the bank‟s profit margin.
Either party to a swap could default on its payments, and so both parties face credit risk.
There is no exchange of principal under an interest rate swap. The principal is exchanged under a currency swap.

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SOLUTION 3.
A. The realization concept states that income should be recognized as and when it is earned. It is not necessary
to wait until the customer actually settles the bill.

SOLUTION 4.
B. The board of directors is ultimately responsible for a company‟s financial affairs. The auditor gives an opi-
nion on whether a company‟s financial statements give a true and fair view of the company. The chief finan-
cial officer reports to the board, either directly or through the chief executive for example. A company secre-
tary typically informs the board of its legal responsibilities.

SOLUTION 5.
B. Non-executive directors are not involved in the day-to-day running of a company. Instead, they are involved
in strategic planning, constructing company policy and monitoring the actions of the executive directors. Se-
lecting the main contractor for a new project is part of the day-to-day running of the company and is likely
to be a task more suitable for the executives.

SOLUTION 6.
C. Individual directors should not be involved in deciding their own remuneration. Remuneration policies and
practices should be designed to support strategy and promote long-term sustainable success. The require-
ments in respect of performance-related pay do not prevent it from being based on share price performance.

SOLUTION 7.
D. A bank‟s net interest margin (NIM) is its total net interest income divided by its average interest-earning
assets. Net interest income is interest received on interest-earning assets less interest paid on interest-earning
liabilities. Fees on customers‟ accounts and shareholder dividends do not affect the net interest income. Cus-
tomers‟ saving accounts are a liability of a bank and so increasing the interest rate paid on these would re-
duce a bank‟s NIM. Customers‟ mortgages are an asset of a bank and so increasing the interest rate on these
would increase the NIM.

SOLUTION 8.
D. No payment is made when convertibles are converted to equity shares. When the loan stock disappears from
the company‟s statement of financial position, gearing would reduce and interest cover would increase (as
the amount of interest payable would reduce). Since the number of equity shares would increase, the earn-
ings would be divided between a larger numbers of shareholders – a process known as dilution.
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SOLUTION 9.
A. A focus on the long term rather than the short term is a key element of sustainability reporting, as sustaina-
bility is concerned with meeting the needs of the present without compromising future generations.

SOLUTION 10.
A. With a finance lease, the value of the asset and the value of the payments due on the lease are shown in the
company‟s statement of financial position.

SOLUTION 11.
The reducing balance approach charges a fixed percentage of the book value each year, so that the whole cost is
charged over the lifetime of the asset.
The reducing balance method trends to charge a heavier proportion of the cost of the assets when they are new and
this is a more prudent approach and more realistic for many assets.
However, the manner and duration over which an asset‟s usefulness diminishes varies according to the nature of
the asset and as this depreciation policy uses the same method and duration for all assets it will not reflect this.
For example:
 A financial asset, such as a leasehold property, has a fixed, defined lifespan.
 Physical assets such as machinery are likely to wear out through use and are likely to deteriorate more rapid-
ly when they are used more heavily.
 Some assets, such as computers, are more likely to be overtaken by new technology long before the end of
their physical lives.
Some assets, such as land and buildings, may increase in value over time, so it may be more appropriate to revalue
them upwards.
This company‟s policy of using a standard life for all assets will be administratively easy.

SOLUTION 12.
A group structure has no legal identity. Members of the group are treated as individual companies in law and so
any loan agreement will be with one or more of the group‟s constituent companies as it is impossible to enter into
a contract, such as a loan, with a group.
It may therefore seem logical to use the financial statements of the company to whom a loan will actually be made
as a basis for assessing the loan, eg looking at its assets available as security, its existing creditors and its levels of
cover for the loan.

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CB1 MOCK SOLUTIONS ACTUATORS EDUCATIONAL INSTITUTE

The consolidated accounts may not provide sufficient detail about any one company at the required level of detail
and it may be harder to extract details about a single company.

It would be possible for a group member to collapse without receiving any support from the other members of the
group who appear in the consolidated accounts.

A group might not allow a subsidiary company to collapse without compensating the subsidiary‟s creditors, be-
cause of the adverse publicity this would create, and so the group‟s consolidated position is also relevant to the
bank.

However, there may be restrictions on the group‟s ability to do this, eg:

 Some subsidiaries may be located overseas and subject to regulations which prohibit the movement of capital
within the group.

 Any non-controlling (minority) shareholders in a particular company within the group might be able to block
transactions that would be damaging to their interests, even if they were potentially beneficial for the group as
a whole.

There may be implicit or explicit support between group members that the bank should consider. For example, the
parent company may have agreed to guarantee a loan to another member of the group; or shared purchasing or
shared marketing might make the individual members stronger that they would be alone.

SOLUTION 13.
As an incremental budget takes a previous budget or previous actual performance as a starting point, and simply
adds on incremental amounts to produce the next budget, it is relatively quick and easy to prepare.

The incremental approach may be appropriate if past figures provide a reliable basis for projecting future figures.

In particular, this may be suitable for Persol‟s sales revenues given its stable markets.

However, incremental budget approaches can conceal or accept existing inefficiencies by basing future budgets on
current figures.

An incremental approach to cost items may therefore be inappropriate for Persol if it is looking for opportunities
to make cost savings as it will need to challenge and reduce costs.

Incremental budgets can encourage unnecessary spending, eg if managers feel they need to spend their allocated
budget in order for the budget to be maintained in future, even if the outlay is not actually required.

Any such overspending could further limit Persol‟s ability to make cost savings.

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SOLUTION 14.
The main potential divergence of interests in a limited company, between those of the owners and managers, is
avoided with sole traders since the owner tends to manage their own business.

However, sole traders could also hire managers to run the business on their behalf, and conflicts may arise if, for
example, they do not agree on the business strategy.
The potential conflicts between the owner of the business and any lenders still exist.

Finance providers may be primarily interested in the security of their lending and only concerned about the busi-
ness during the term of any loans whereas the sole trader is more interested in the long term profitability and pros-
pects of the business.

Sole traders may have employees who are not owners of the business and this is another potential source of con-
flicts. For example, employees may be concerned about levels of salaries and benefits and also about job security,
which may conflict with the owners; desire for profitability and efficiency.
Sole traders may have conflicts with other stakeholders, eg:

 Customers and/or suppliers – in particular about early/late payment for any goods purchased

 A landlord that leases a building to a business may wish that the rent levels would increase.

 The tax authorities – about the amount of profit on which tax should be paid.

SOLUTION 15.
Establishing its own operation abroad (ie internal growth) has the advantages that:

 Company ABC will retain control, eg of which countries to establish operations in and what strategy to
adopt.

 There may be parts of the overseas company that are not required (for example, human resources, IT Sys-
tems, accounting functions) and would need to be closed down if the company were to expand by acquisition.

 Company ABC could impose its own culture and practices, eg salary scales, work ethics and contracts of
employment on any operations that it establishes overseas.

External growth (ie achieved by buying the existing operations) has the advantages that:

 Company ABC would obtain the skills of the existing management and staff in terms of running the compa-
ny, and in terms of customer relationships and local regulations.

 The overseas subsidiary may already have the benefit of diversification across many countries.
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 It will achieve substantial expansion in a fraction of the time required to build the operations.

 It may be cheaper to buy existing operations than to set them up from scratch.

 The overseas subsidiary may already have a good brand and a good reputation, achieved by extensive mar-
keting abroad.

 Company ABC may consider the opportunity cost of capital and believe that the purchase is a good use of its
available funds.

 It may be better to buy the overseas subsidiary than have it as a computer.

SOLUTION 16.
STATEMENT OF FINANCIAL POSITION

In the non-current assets, the factory will now be valued at £200,000 (replacing the previous value based on cost
less accumulated depreciation), so total assets will increase by £50,000.

In the equity section, the revaluation reserve section of “other reserves” will increase by £50,000, so the total eq-
uity will increase by £50,000.

Statement of comprehensive income

The revaluation does not affect this year‟s depreciation figure of £10,000, which will be included in the cost of
sales in the statement of profit or loss.

In future, the depreciation figure will be based on the new valuation of the factory. So assuming no change to the
approach to depreciating the asset, there will be a higher figure for depreciation in future years.

In the „other comprehensive income‟ section, „gains on revaluation of the factory‟ will be included of £50,000, so
total comprehensive income will increase by £50,000.

STATEMENT OF CHANGES IN EQUITY

The increase in the value of the factory will be recorded under „fair value gains‟ and will result in an increase in
the revaluation reserve, which is part of „other reserves‟, by £50,000.

SOLUTION 17.
Being a private company may make it more difficult for Burgon to issue debentures.

Investors would have more confidence in Burgon‟s security if it had listed shares and its accounts complied with
accepted standards and levels of disclosure required by a stock exchange.

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Burgon may also be harder to get a credit rating as a private company.

So it may have to pay a high rate of interest as it will be seen as riskier than a listed company.

Burgon may have to put a fixed charge on a very sizeable asset or properly in order to raise the debt, meaning that
it could then not sell the asset without bondholders‟ approval.

Requiring such external approval may be particularly undesirable for a private company, with a smaller number of
shareholders many of whom may be involved with running the company.

Burgon may not have a suitable asset to secure the debenture g9iven the large amount needed.

SOLUTION 18.

HOW INTENDED TO ACHIEVE GOVERNMENT’S AIM

The tax changes will mean individual shareholders will become less keen to receive dividend income and more
keen to accrue gains.

The government‟s aim may be achieved if, as a result, companies do retain more earnings in the business to invest
rather than paying dividends to shareholders.

PROBLEMS THAT MIGHT ARISE

If companies‟ shareholders are largely institutions rather than individuals, then companies are less likely to take
the tax changes into account when determining how much dividend to pay out.

Even if they do retain earnings, companies may not then invest them as the government hoped, eg they could
simply hold more cash.

Higher income tax reduces disposable income and so leaves individual investors with less to invest in company
shares (reducing capital available to companies for investment).

Other types of assets, for example assets that do not pay an income (such as fine art) may become more attractive,
which would also reduce investment in company shares.

The tax changes may not change companies‟ levels of investment at all, as changing the tax regime for individuals
is at best an indirect way of the government achieving its aim and companies may simply ignore the intended
„signal‟.

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SOLUTION 19.

(i) ANALYSIS USING RATIOS

Ratio Company Y Company Z

Earnings per share (see note 1)

£450,000 £350,000
𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝑝𝑟𝑜𝑓𝑖𝑡𝑓𝑜𝑟𝑡 ℎ𝑒𝑦𝑒𝑎𝑟 )
= 7.5𝑝 = 5.83𝑝
= 6,000,000 6,000,000
𝑛𝑢𝑚𝑏𝑒𝑟𝑜𝑓𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦𝑠 ℎ𝑎𝑟𝑒𝑠

Price earnings ratio

200 200
𝑚𝑎𝑟𝑘𝑒𝑡𝑝𝑟𝑖𝑐𝑒 = 26.7 = 34.3
= 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑝𝑒𝑟𝑠 7.5 5.83
ℎ𝑎𝑟𝑒

𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑝𝑒𝑟𝑠 ℎ𝑎𝑟𝑒 6.25 4.0

Dividend yield (see note 2) = 𝑚𝑎𝑟𝑘𝑒𝑡𝑝𝑟𝑖𝑐𝑒 = 3.1% = 2.0%
200 200

𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑝𝑒𝑟𝑠 ℎ𝑎𝑟𝑒 7.5 5.83

Dividend cover (see note 3) = 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑝𝑒𝑟𝑠 ℎ𝑎𝑟𝑒 = 1.2 = 1.46
6.25 4.0

Return on capital employed (all capital) £600,000 + £120,000 £600,000 + £12,000

£3,500,000 £3,100,000
𝑝𝑟𝑜𝑓𝑖𝑡𝑏𝑒𝑓𝑜𝑟𝑒𝑡𝑎𝑥𝑎𝑛𝑑𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
= 𝑠ℎ𝑎𝑟𝑒𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑎𝑛𝑑𝑟𝑒𝑠𝑒𝑟𝑣𝑒 𝑠+𝑙𝑜𝑎𝑛𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 20.6% = 19.7%

Either ROCE (share capital)

£600 ,000 £600 ,000
𝑝𝑟𝑜𝑓𝑖𝑡𝑏𝑒𝑓𝑜𝑟𝑒𝑡𝑎𝑥 £2,000 ,000
= 30% £3,000 ,000
= 20%
= 𝑠ℎ𝑎𝑟𝑒𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑎𝑛𝑑𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠

Or return on equity (ROE) £450,000 £350,000

£2,000,000 £3,000,000
𝑝𝑟𝑜𝑓𝑖𝑡𝑎𝑓𝑡𝑒𝑟𝑡𝑎𝑥𝑎𝑛𝑑𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
= 𝑠ℎ𝑎𝑟𝑒𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑎𝑛𝑑𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠 = 22.5% = 11.7%

Net asset value per share (see note 4) £2,000,000 £3,000,000

6,000,000 6,000,000
𝑠ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟 𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦 −𝑖𝑛𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒𝑠
= 𝑛𝑢𝑚𝑏𝑒𝑟𝑜𝑓𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦𝑠 ℎ𝑎𝑟𝑒𝑠 =33.3p = 50.0p

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Net asset value compared to share price 33.3 50.0

𝑛𝑒𝑡𝑎𝑠𝑠𝑒𝑡𝑣𝑎𝑙𝑢𝑒𝑝𝑒𝑟𝑠 ℎ𝑎𝑟𝑒
200 200
= 𝑚𝑎𝑟𝑘𝑒𝑡𝑝𝑟𝑖𝑐𝑒 = 16.7% = 25%

Asset gearing (see note 5) £1.5m £0.1m

𝑑𝑒𝑏𝑡
£2.0m + £1.5m £3.0m + £0.1m
= 𝑑𝑒𝑏𝑡 +𝑒𝑞𝑢𝑖𝑡𝑦
= 42.9% = 3.2%

NOTES:
𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦𝑠 ℎ𝑎𝑟𝑒𝑐𝑎𝑝𝑖𝑡𝑎𝑙
1. Number of shares calculated as 𝑝𝑎𝑟𝑣𝑎𝑙𝑢𝑒𝑜𝑓𝑠 ℎ𝑎𝑟𝑒𝑠
. This is 6m for both companies.

𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 £375,000
2. The dividend per share for Company Y has been calculated as = =6.25p and
𝑛𝑢𝑚𝑏𝑒𝑟𝑜𝑓𝑠 ℎ𝑎𝑟𝑒𝑠 6,000 ,000
£240,000
for Company Z as 6,000 ,000 = 4.0p

3. As an alternative to dividend cover, the payout ratio = 1/dividend cover can be given equivalent credit
and is 83% for Company Y and 69% for Company Z.
4. Intangibles are assumed to be zero.
𝑑𝑒𝑏𝑡 1.5
5. The other definition of gearing ( 𝑒𝑞𝑢𝑖𝑡𝑦 ) is also acceptable. For Company Y this is 2.0
= 75% and for
0.1
Company Z is3.0 = 3.3%.

CONCLUSIONS
PRICE EARNINGS RATIO
Company Y has a lower price earnings ratio than Company Z. This could imply any of the following:
 Company Y has poorer growth prospects than Company Z
 Company Y‟s earnings are unusually high in this year (or Company Z‟s are unusually low)

 Company Y‟s earnings are more risky and/or more volatile than those of Company Z

 Shares in Company Y are relatively cheap compared to those in Company Z.

DIVIDEND YIELD
Company Y has a higher dividend yield. This might reinforce the suggestion that company y is undervalued
compared to company Z, or more likely simply reflects company Y paying more of its earnings out as divi-
dends than company Z.

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DIVIDEND COVER/ PAYOUT RATIO

Company Y has a lower dividend cover (higher payout ratio) than Company Z. So Company Y is distribut-
ing more to its shareholders and retaining less of its profits within the company than Company Z. This might
indicate lower future dividend growth.

RETURN ON CAPITAL EMPLOYED (ALL CAPITAL)

The companies have a similar return on all capital employed suggesting that they are equally good at gene-
rating profit for the investors in the company.

ROCE (SHARE CAPITAL) OR ROE

Looking at both of these ratios, Company Y has a higher return on share capital than Company Z. Company
Y is using its shareholders‟ equity capital more effectively to generate profits for shareholders.

This may be due to the fact that Company Y is making far greater use of cheaper debt finance and it is able
to obtain debt finance more cheaply (at 8% rather than 12%).

However, the gap for Company Y between these ratios and the return on all capital employed indicates that
the company has a large amount of debt in its capital structure which may be a concern to the shareholders.

NET ASSET VALUE

Company Y has a lower net asset value per ordinary share (NAV) than Company Z. Thus if the company
were wound up (at the present time), a shareholder in the Company Z may receive more than a shareholder
in Company Y.

The ratio of the net asset value per share to the market price can also be considered, and this is higher for
Company Z. This might mean Company Z might be a takeover candidate (although this in unlikely whilst
the NAV remains below the market price).

However, the ratios may be misleading as the asset valuations in the accounts may not reflect the true value
of the assets.

GEARING RATIO
Company Y has a much higher gearing ratio than Company Z, which has minimal debt finance. The addi-
tional funds made available by debt finance would give Company Y greater potential for growth.

However, higher gearing also makes Company Y more vulnerable to the downturn in the business cycle and
reduces the funds available to shareholders if the company were to be wound up.
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(ii) ADDITIONAL INFORMATION

Course Reference: Chapter 15.

The following would be needed:

 More than one year‟s accounting figures, to enable the trend in figures to be calculated for both compa-
nies.

 Information on accounting policies from the notes to the accounts eg depreciation, revaluation of fixed
assets, consolidation methods.

 Complete set of financial statements, eg statement of financial position, cashflow statement

 Other reports, eg directors‟ and auditors‟ report, non-financial reports such those relating to sustainabil-
ity or corporate governance etc.

 Information on the nature of both companies and the sectors in which they operate, eg are Y and Z in
the same sector? What are the prospects for that/those sector(s)?

 Qualitative information for reach company such as quality of management and staff, strategy for the fu-
ture/business plans, ethical stance etc.

 Investment preferences of the friend, such as desire for income or growth, risk appetite, tax position etc.

SOLUTION 20.
(i) USE OF MONTE CARLO SIMULATION TO EVALUATE THIS BUSINESS

Monte Carlo simulation is a good way to assess complicated situations where there are many interactions
between variables.

The output will be a distribution of possible outcomes, which may be examined to see the likely average
profitability, the spread of profits, and any outliers.

The number of simulations would be determined by the computing power, the time taken to run the simula-
tions, and the likely improved accuracy (or not) achieved by a higher number of simulations.

Mortgage defaults are likely to be correlated, eg a recession leading to many defaults in certain areas of the
country. These correlations could be built into the model.

The model output should help the bank see the impact of these interactions between the different variables.

The correlations are likely to be determined from past data looking over a long period of house price information.

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The default rates may be linked to the level of interest rates, and a connection would be built into the Monte
Carlo model.
Past data may be difficult to obtain especially as the bank is new to this market.
(ii) DISCUSS THE RESULTS OF THE MODEL AND COMMENT ON THE DIRECTOR’S VIEWS
Results of the model
There appear to be a large group of unfavourable results at the left-hand side of the chart.
These results would lead to annual losses of £300m or more, which could have a significant impact on the
bank, eg forcing the bank into administration, or to raise more capital.
Although the occurrence of these outcomes is considerably less likely than the occurrence of profits in the
range £0m to +£400m, these extreme results need further investigation.
Director‟s views
The director‟s comment on the profitability of the business is correct. It looks as though the business will
generate profits of around £200m in each year.
The director‟s comments on the predicatable and low-risk nature of the profits do not look
(iii) WHETHER USING A DISCOUNT RATE OF 7% (COST OF DEBT) IS APPROPRIATE
If the cashflows are discounted at 7% rather than 12%, the net present value of the project will be higher,
and the project will therefore appear to be more profitable.
However, it can be argued that it is wrong to assess a project based on the actual cost of the capital raised to
finance the project.
This is because the new finance raised will also have an impact on all the existing projects that the bank is
currently undertaking.
Using the cost of debt ignores the fact that the business is supported by equity capital that needs to generate
a return to shareholders.
Where the cost of debt is used, it should be the net cost of debt, not the gross cost of 7%.
(iv) CALCULATION OF WACC
Since the bank‟s current cost of equity is 12% and has a beta of 1.3, we can estimate the equity risk premium
in the market using the formula:
12% = 5%+1.3×equity risk premium
Therefore, the equity risk premium is 5.38%.
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If the new debt was raised, the beta of the equity would rise according to the formula:

𝑑𝑒𝑏𝑡
𝛽 𝑔𝑒𝑎𝑟𝑒𝑑 = 𝛽𝑢𝑛𝑔𝑒𝑎𝑟𝑒𝑑 × 1 + 𝑒𝑞𝑢𝑖𝑡𝑦 × 1 − 𝑡

Where t = corporation tax rate and „debt‟ and „equity‟ are the amounts of these two types of capital in the
company‟s structure.
1,000
Therefore: 𝛽 𝑔𝑒𝑎𝑟𝑒𝑑 = 1.3 × 1 + 3,000 × 1 − 0.24 = 1.63

The new cost of equity capital would rise to:

𝑔𝑒𝑎𝑟𝑒𝑑
𝑅𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑓 + 𝛽 𝑔𝑒𝑎𝑟𝑒𝑑 × equity risk premium

= 5%+1.63× 5.38% = 13.77%

The bank‟s WACC would fall to:
1 3
× 7% × 1– 0.24 + × 13.77% = 11.66%
4 4
The reduction in the WACC is due to the beneficial effect of debt on the bank‟s tax liability outweighing the
increased cost of equity.
Since the new WACC of 11.66% is lower than the original WACC of 12%, using loan stock to finance the
new business project would increase the NPV and so the profitability of the project.
(v) LIMITATIONS OF USING WACC
If projects are very different in terms of the level of systematics risk posed, then it is better to assess each
project using a discount rate that reflects the systematic risk of the project.
The buy-to-let project might be exposed to greater systematic risk than the bank‟s usual business, so the dis-
count rate used to appraise the project should be higher than the WACC, in which case the new project
would be less profitable than originally thought.

CA PRAVEEN PATWARI 13 JAI SHREE RAM