Actuarial Society of India

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1 Actuarial Society of India EXAMINATIONS November 2004 SUBJECT - 108: Finance and Financial Reporting Indicative Solution S-108 Page 1 of 7

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. S-108 Page 2 of 7

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 a) The firm s asset beta and the beta of portfolio of liabilities should be equal Therefore, asset beta is = = S-108 Page 3 of 7

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 = ( )/1.2 = 0.125=12.5% therefore, required return = 5% (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) S-108 Page 4 of 7

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 X Advertisers Profit & Loss Account for the year ended Revenue Rs. '000 Advertising Revenue Expenses Salaries 3000 Depreciation Insurance 1000 Interest Profit Before Tax Tax Profit After Tax S-108 Page 5 of 7

6 X Advertisers Balance Sheet as at Liabilities Rs. '000 Assets Rs. '000 Share Capital Fixed Assets Gross Fixed Assets Retained Earnings Less Acc Dep Opening Balance Add: Profit for the year Deposits Income Tax Payable Prepaid Insurance 1000 Accounts Receivable Cash 2500 Total Liabilities Total Assets 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 e) Reduces capital and cash S-108 Page 6 of 7

7 II Reserves = = 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. S-108 Page 7 of 7

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