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(1)

Actuarial Society of India

EXAMINATIONS

November 2004

SUBJECT - 108: Finance and Financial Reporting

Indicative Solution

(2)

1 D

2 C

3 B

4 D

5 D

6 A

7 B

8 C

9 B

10 D

11

Trade credit is short-term finance offered by vendors.

Trade is done on the basis that goods are supplied on credit.

Payment is made after receipt of the goods.

No explicit charge of interest. Included in purchase price.

Debt factoring is short-term finance offered by factors.

Loan secured on debtor’s balances.

Debtor pays to factor.

Recourse / Non – recourse factoring.

12.

A typical manufacturing company would use swaps either to decrease the cost of debt or to manage the risks. Of course, it might also use it for speculation but that is highly unlikely.

Risk Management

A company, which has short-term liabilities linked to floating interest rates, but long term fixed rate assets, would use interest rate swap to achieve a more matched position and to reduce the actuarial risk.

Similarly, a company, which has assets in one currency but liabilities in another currency would use currency swap to reduce the currency risk.

Cost of Debt

If a company has a comparative advantage in borrowing at a floating rate (compared to fixed rate) than the company might be able to combine the swap with floating rate to achieve the same objective of borrowing at a fixed rate but at a lower rate.

Similarly, if a company has a comparative advantage of borrowing in a different currency rather than the required currency, it might be able to combine the currency swap to lower the total cost of borrowing in the required currency.

(3)

13

The most convincing reason for making a scrip issue is that it tends to indicate some confidence on the part of management. It is, therefore, a relatively inexpensive method of signalling a positive impression.

There may be advantages in having an issued share capital of more than Rs X crore. A scrip issue is a cheap means of achieving this.

They draw attention to the fact that the company’s past successes have been sufficient to create the necessary reserves to fund the issue.

Shareholders might view the bonus shares as a “free” gift.

14

Accounting principles followed,

Accounts represent true and fair picture of the affairs, Check on systems and procedures,

Statutory requirement,

Qualifying remarks on any lapses, inconsistencies, assumptions, accounting policies, Reporting to shareholders on the reasonableness of financial statements

15

To repurchase 200,000 shares, the company needs Rs. 40 million. The inherent assumption in the stated calculation is that Net Profit remains at 10 million.

But, to repurchase substantial part of the outstanding shares, one needs to reduce the asset holding to generate the cash.

Assets are necessary to support the profits. Assets represent investments and higher the investment, higher should be the profit. Therefore, with a reduction in assets, we should be expecting a proportional decrease in profits.

In case the income declines proportionately to decline in assets, then the net profit should be (Rs.

10 million x 0.8=) 8 million ..and EPS should be 10.

Assuming P/E ratio remains same the share price must remain at 200.

16

a) The firm’s asset beta and the beta of portfolio of liabilities should be equal.

Therefore, asset beta is =

200 40 100

200 2 . 1 40 2 . 0 100 0

+ +

× +

× +

× = 0.7294

(4)

b) The action of the firm doesn’t changes either the composition of the assets or the total assets.

Consequently the asset beta doesn’t change.

c) Using CAPM we get:

risk premium = (0.2-0.05)/1.2 = 0.125=12.5%

therefore, required return = 5% + 0.7294 (12.5%) = 14.12%

17 Central bank has a key role in boosting the confidence of the investors in the financial markets.

The statements of the chief officer of the central bank are interpreted by the players with great care and affects the future actions and happenings in the financial markets. The status of an independent central bank is seen as a major strength of the country. The main roles of the central bank are:

Regulator

Govt. debt manager

lender of last resort to banks Inflation management Interest rates management Reporting on health of economy Currency management

Issues currency

Provides settlement system for Govt. Securities Monitors foreign reserves

Open Market Operations

Provides liquidity in money market

18

No Change:

Low dividend, tax on dividend now removed, similar dividend declared by similar companies, dividend as expected, reduction of cost of capital (discount rate) offsetting the dividend reduction, Investment of excess earnings (net of dividend) in zero NPV project

Increase in Market Price:

Lower dividend declared by similar companies, dividend higher than expected, low interest rates, reduction of cost of capital (discount rate), Investment of excess earnings net of dividend in +ve NPV project

Decrease in Market Price:

Higher dividend declared by similar companies, dividend lower than expected, high interest rates, Investment of excess earnings net of dividend in -ve NPV project

19.

ROCE is ‘Return on Capital Employed’. Two definitions based on definition of ‘capital’.

ROCE1 = PBIT / (Share capital + reserves + long term debt) ROCE2 = PBT / (Share capital + reserves)

(5)

If ROCE1 used, then impact of higher interest not factored.

If ROCE2 used then profitability has improved due to leverage effect. However, the high D/E means high financial risk, i.e. lower than expected sales may lead to higher losses, as interest payment remains the same.

20

Revenue Rs. '000

Advertising Revenue 200000

Expenses 41000

Salaries 3000

Depreciation 10000

Insurance 1000

Interest 27000

Profit Before Tax 159000

Tax 15000

Profit After Tax 144000

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Profit & Loss Account for the year ended 31.03.2003

(6)

Liabilities Rs. '000 Assets Rs. '000

Share Capital 200000 Fixed Assets 260537

Gross Fixed Assets 290537

Retained Earnings 159000 Less Acc Dep 30000

Opening Balance 15000

Add: Profit for the year 144000 Deposits 30000

Income Tax Payable 15037 Prepaid Insurance 1000

Accounts Receivable 80000

Cash 2500

Total Liabilities 374037 Total Assets 374037

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Balance Sheet as at 31.03.2003

21

Three statements are:

a. Profit & Loss - Income less expenses for the year, Depreciation, tax, dividend

P&L depicts the financials of the financial year and sums up all income deducting expenses / taxes / dividends to arrive at net profit retained

b. Balance Sheet – snapshot on a day, assets /liabilities. A check on the accounts as assets should match the liabilities

c. Cash Flow - from operations, financing of capital transactions. Shows how cash is being generated and where its getting consumed

22

I] Balance sheet equation: Assets = Capital + Liabilities II]

a) Investments reduce cash increases no impact on Assets

b) Declaration doesn’t have impact on cash. The Provision for dividend increases (liability) and Retained Earnings (liability) decreases

c) Increases cash on assets side and capital on liabilities side

d) Increase in assets side along with increase in revenue on liabilities side

(7)

II

Reserves = 300 + 50+25+100-50-150 = 275

Goodwill arises in case of merger / acquisition, wherein a value higher than the book value is paid.

Therefore, the excess value is called ‘goodwill’ whose value is amortized over a period of time.

References

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