May 2001 Examinations

Subject 108 (Finance and Financial Reporting) Indicative Solution

1) Possible reason for high P/E ratio: Low risk company Prospects of high growth Share overvalued Industry standard Zero coupon bond: Bond that offers no interest payments Issued at huge discount Also known as deep discount bonds Commercial paper: Short term debt instrument Suitable for large companies wishing to raise working capital Tradable Not secured Leasing Agreement for renting the good for a specified period Ownership is retained by the lessor throughout 20 % C Rs 18.57 Hire purchase Agreement for eventual purchase of the good Ownership passes to the buyer After the specified term

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Double taxation relief is intended to reduce the extent to which individuals and companies which are subject to income and corporation tax are taxed twice on the same income. Tax paid overseas on overseas income can be offset against the local tax liability on that income. This is up to a maximum of the tax which would have been paid in the local country. Double tax relief is generally available on income only, not on capital gains. [4] An interest rate swap would be the most appropriate form of derivative. 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 rat loan. The fixed payment can be thought of as interest payments on a deposit at a fixed rate, while the variable payments are the interest on the same deposit at a floating rate. The deposit is purely a notional on, no exchange of principal takes place. [4] The main advantage of underwriting a share issue is that there is no risk of the company being left with unsold shares. If the rights issue proves unattractive to shareholders then the company may have insufficient funds to finance the project for which the shares were being issued. It may prove difficult and expensive to raise additional long term finance by some other means. The main disadvantage of underwriting the issue is that the company will have to incur fees which may prove substantial. While this might be a worthwhile investment, it is desirable to minimize such costs wherever possible. The rights issues is likely to prove successful if the new shares are sold at reasonable

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discount. While any discount is likely to make the shares attractive, the volatility of the stock market and of the company itself should be considered. If the share price is likely to move rapidly then the rights price could exceed the market price, thereby making the new shares unattractive. The extent to which the company can persuade the markets that the new funds will be invested profitably will also have some bearing on the need for an underwriter. If the company has a viable project then the share price could rise in response to that information and that will make the issue even more attractive. The company should discuss the likely market perception of the project with independent experts such as the company's merchant bankers. [6] 11) The financial statements of a group are consolidation of the financial statements of the individual group members. Unlike their separate statements, the group accounts portray an economic entity rather than a separate legal being The group accounts will include balance such as goodwill on acquisition and minority interest, none of which arise in the context of an individual company. The preparation of the statements also involves the cancellation of a variety of transactions and balances which exist between the group members. [6] A project's 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. 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 large absolute increase in wealth from another project. Accepting a project with a positive net present value increase the shareholders' wealth by the NPV of the project. The fundamental objective of business is to increase shareholder NPV. That suggests that NPV is the most reliable measure of a project's worth because it is automatically consistent with the needs of the shareholders. The company should choose project A. [6] 13) Gross Redemption Yield g is given by solving. 105 = 12.a10 + 100 v ^10 @g, assuming yearly coupon payments, next payment due exactly after a year [1] g = 11.01% Interest Yield d is given by 12/105. d =11.4% Holding period return h is given by solving. 105 = 12. a 5 + 98.v ^ 5 @h, same assumptions as above h = 10.3% [Maximum marks 6] 14) Methods of charging depreciation: Straight-line-method charges a fixed portion of the cost of the fixed asset, over the useful lifetime of the asset. [1] Depreciation rate = (Gross value - Estimated residual value) / Estimated useful lifetime, applied to the original value. [1] Reducing balance method charges a fixed percentage of the net book value (ie depreciated value to date). [1] Depreciation rate = 1 - (Estimated residual value/Gross Value) ^ (1/n) applied to net book value. [1] Example [1] [1] [1] [] []

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Gross value = 100 Estimated residual value = 10 Estimated useful lifetime = 3

Straight-line Year 1 Year 2 Year 3 Resident value [Maximum marks 6] 15)

Reducing balance 30 53.6 30 24.9 30 11.5 10 10

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Advantages of listing: Can raise new capital Can raise additional capital in future Can provide an exit rout for existing shareholders Can offer quoted shares as consideration for acquisitions Listing would enhance the status of the company and hence it's bargaining powers It would provide an objective method of valuation of their investments for the owners of the company The company can offer employee Stock Option Scheme for its employees It would facilitate if the company were to be widely held It would enhance the public awareness about the company which may in turn increase its sales. [Maximum marks 8]

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Accounting ratios: Gross profit ratio Net profit ratio Return on capital employed Stock turnover Current ratio Trade debtor Collection period Trade creditor Payment period 1996 525/1500x100=35% 525/975x100=53.8% 275/1000x100= 27.5% 975/100=9.75 times 500/80= 6.3:1 1997 600/1900x100-31.6% 600/1300x100=46.2% 250/1250x100 = 20% 130/200 = 6.5 times 1000/210 =4.8:1

375/1500x365 = 92 days 800/1900x365 = 154 days 80/995/365 = 30 days 200/1400x365 = 53 days [1 mark each]

Comments: The company increased its sales in 1997 by Rs 400 million (26.7%). It seems to have done this by reducing its profit on goods sold, as the gross profit has reduced. The increased activity probably accounts for the additional expenses. As a result, its net profit ratio fell to 46.2% and the net profit was reduced by Rs 25 million. HJK's liquidity position is still healthy, as indicated by the current ratio, although it has fallen from 1996. The debtor collection period has increased substantially (as has the trade creditors payment period). This may be as a result of a deliberate policy to stimulate sales, or it may reflect poor debtors management. Not surprisingly, the cash position has deteriorated over the period, with the company having an overdraft by the end of 1997. Increased trading activity does not always ensure a company's survival. If the company cannot pay its debts as they fall due, it may be unable to continue to operate. HJK Ltd should pay close attention to its cash flow position.

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XYZ Ltd Profit and Loss account for the year ended 31/03/2000 (Rs.`000) Turnover 16000 Factory running costs 1200 Manufacturing wages 1300 Materials consumed 1600 4100 Gross profit 11900 Factory depreciation 460 Machinery depreciation 2000 Interest payable 1680 Sales salaries 1600 Administrative expenses 960 6700 Operating profit 5200 Taxation 1290 Dividend 1400 2690 Retained profit for the year 2510 XYZ Ltd Balance Sheet as at 31/03/2000 (Rs.`000) Tangible fixed assets (Note 1) Current assets Stock 700 Trade debtors 1300 2000 Current Liabilities Bank overdraft 700 Trade Creditors 600 Taxation 1290 Proposed Dividend 1400 Net current Liabilities Long term loan Share capital Revolution reserve Retained profits 32000

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3990 1990 12000 12000 3500 2510

13990 18010

18010

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Note 1: Tangible fixed assets

Gross value as at 31/03/1999 - Depreciation as at 31/03/1999 + Additions during the year - Depreciation for the year + Adjustment on revaluation Net Value as at 31/03/2000 [Maximum marks 20] Factory 23300 1340 0 460 3500 25000 Machinery 12300 6000 2700 2000 0 7000 Total 35600 7340 2700 2460 3500 32000

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