THIRD YEAR EXAMINATION: JANUARY 2021 Finance and Financial Reporting Time Allowed: 2 hours Please make sure that your student ID and the exam code are clearly marked on each answer that you submit. Full marks will be obtained by correctly answering ALL questions. The numbers in the margin indicate approximately how many marks are available for each part of a question. The total mark for all questions is 100. Calculators may be used in this examination. 1 CONTINUED Cooltech PLC Trial Balance 2020 Entry ￡m Entry ￡m Sales 10,878 Bad Debt Provision 95 Purchases 3,701 Bank Overdraft 10 Wages (factory) 24 Factory (initial construction cost) 500 Advertising Expenses 140 Factory (deprn provision at 1 Jan) 100 Business Rates 7 Delivery Vehicles (initial cost) 320 Factory Energy Costs 425 Delivery Vehicles (deprn provision at 1st Jan 2020) 240 Insurance Costs 39 Machinery (initial cost) 4,950 Audit fees 15 Machinery (deprn provision at 1st Jan) 1,400 Rent 15 Share Capital 9,250 Interest Paid 54 Stock at 1st Jan 280 Interest earned 178 Trade Payables 402 Wages (distribution) 35 Trade Receivables 190 Wages (administration and sales) 55 Cash 1,865 Research and Development costs 2,829 Loan Capital at 1st Jan 2,800 Investments 10,092 Additional notes 1. Stock in hand at year-end 2020 is valued ￡320m at cost and ￡422m at net realisable value. 2. Tax, of ￡174m, for the current accounting period is due. 3. Loan stock of ￡900m was redeemed in 2020. The remaining loan is due to redeem in 2026. 4. Rent includes a pre-payment of ￡3m which relates to the next accounting period. 5. Depreciation for the current accounting period needs to be accounted for as follows: Factory. Life of 10 years from construction. Straight-line method. Scrap value ￡0. Vehicles. Life 4 years from purchase. Reducing balance method. Scrap value ￡20m. Machinery. Life of 6 years from purchase. Straight-line method. Scrap value ￡750m. 6. Retained profits at 1st Jan 2020 were ￡1,083m and a dividend of ￡925m is payable for 2020. Market Information as at 31st December 2020 Additional information for 2020 Shares Outstanding 9,250m Cost of goods sold ￡5,450m Credit sales ￡1,150m Market Value per Share ￡15.25 Credit purchases ￡4,350m 2 CONTINUED 1. (a) You work as an accountant at the fintech company Cooltech PLC, which is required to provide a Statement of Profit or Loss (P&L) and a State- ment of Financial Position (Balance Sheet) for the year 2020 accord- ing to the IFRS. Use the trial balance and the additional notes relative to the year 2020 (appearing on p2) to prepare the P&L and Balance Sheet. [25 marks] (b) Using the Statement of Profit or Loss and the Statement of Financial Position you obtain, together with other data provided on p2, calculate the following financial ratios relative to the company for the year 2020. (i) ROA (ii) ROE (iii) Net Profit Margin (iv) Acid Test (v) Payables Turnover Period (vi) Inventory Turnover (vii) Gearing (viii) Asset Cover (ix) P/E Ratio (x) Dividend Yield [10 marks] [Question total: 35 marks] 3 CONTINUED 2. In the following multiple choice questions, simply state which answer—A, B, C or D— is correct. (a) Which of the following statements is correct A A bank overdraft is more flexible than a fixed term loan. B A bank overdraft must be repaid within a year. C Banks cannot recall overdrafts because doing so would put customers out of business. D Banks generally secure overdrafts against specific assets. [2 marks] (b) Which of the following is NOT a correct interpretation of the prudence concept A An asset that cost $400,000 was professionally revalued at $500,000 and that valuation has been recognised in the financial statements. B An asset that could be sold for between $500,000 and $800,000 has been valued at $400,000 in the financial statements. C An asset that could be sold for between $500,000 and $800,000 has been valued at $600,000 in the financial statements. D An intangible asset could be worth up to $800,000, but the asset’s value has not been recognised in the financial statements. [2 marks] (c) Which of the following best reflects the significance of a company receiv- ing an unmodified audit opinion A The company is a good investment. B The company’s financial statements are accurate. C The company’s financial statements can be relied upon for steward- ship purposes. D The directors have not abused their position of trust. [2 marks] 4 Question 2 continued overleaf Question 2 continued (d) Which of the following best explains why intangible assets are excluded from the calculation of asset cover A Intangible assets are generally worthless. B Intangible assets are not owned by the company. C Intangible assets cannot be transferred to the lender in the event of default. D Intangible assets may be difficult to realise in the event of the com- pany’s failure. [2 marks] (e) It has been suggested that the long term returns from investing in equities are higher than those for many other types of investment. What does this tell us about the cost of equity to the issuing companies A Equities are a relatively expensive source of finance. B Equities are a relatively inexpensive source of finance. C It tells us very little because there is no link between the cost of equity and the returns offered to shareholders. D The cost of equity finance is excessive. [2 marks] (f) A typical cash flow statement adds depreciation back to operating profit in order to arrive at cash generated from operations. Which of the fol- lowing explains the treatment of depreciation A Depreciation affects cash flow but not profit. B Depreciation affects profit but not cash flow. C Depreciation is a subjective estimate. D Depreciation is not an operating expense. [2 marks] 5 Question 2 continued overleaf Question 2 continued (g) A company has 500,000 ￡1.00 ordinary shares in issue. The current market price is ￡1.80. The company will make a rights issue later today, issuing 50,000 new shares at a price of ￡1.50. What is the theoretical ex-rights price of the company’s shares A ￡1.50 B ￡1.65 C ￡1.77 D ￡1.80 [2 marks] (h) The purchase of a business for more than the aggregate of the fair value of its separate identifiable assets less liabilities results in the creation (in the balance sheet) of a: A share premium account B reserve account C suspense account D goodwill account [2 marks] (i) Which of the following problems is most likely to be overlooked by a ratio analysis of a company’s financial statements A Poor profitability B Liquidity problems C High gearing D Substantial contingent liabilities [2 marks] 6 Question 2 continued overleaf Question 2 continued (j) A company has 12m shares in issue and $7m nominal in outstanding bonds (with a face value of $100). The current share price is $1.23 and the market price of the bond is $92.50. The average rate of tax it pays on profits is 22%. According to Modigliani and Miller’s second proposition, what is the value of its tax shield A $3.25m B $1.42m C $5.05m D $11.51m [2 marks] [Question total: 20 marks] 3. Cooltech’s capital allowances for the year were ￡650m, tax relief on overseas earnings was ￡112m, while its brought forward loss was ￡2,128m. Using the data on p2 and the P&L, calculate its taxable profit and its average tax rate. [7 marks] 4. At 30 June, 2020, Cooltech PLC was confronted with an investment op- portunity. The table below reports the predicted cashflows involved in the project (figures in ￡m payable/receivable on 1 July in the year in question). Project Year 2021 Year 2022 Year 2023 Year 2024 Year 2025 Project L -950 100 205 400 700 (a) For the project, calculate the following at 10% and at 14%. (i) Net Present Value (NPV) as at 1 July 2021. (ii) Profitability Index. (iii) Discounted Payback Period. [8 marks] (b) Estimate the project’s internal rate of return (IRR). [2 marks] [Question total: 10 marks] 7 CONTINUED 5. Cooltech is considering different ways of raising about ￡3, 000m in order to undertake a profitable secondary investment project. The company wants to issue new shares through a 1 for n rights issue at a subscription price of ￡3.45 for each new share. (a) Using the data on p2, calculate (as at the 1st January 2021) the max- imum integer n for which the rights issue would cover the funding re- quirement. [2 marks] (b) Assuming the value of n you calculated above is used, calculate: (i) The total new shares issued, total capital raised through the issue, company’s market value before and after the share issue and the shares outstanding after the issue. (ii) The theoretical ex-rights share price and the rights value per share. [6 marks] (c) Why does the subscription price need to be below the market value of the shares [1 mark] [Question total: 9 marks] 8 CONTINUED 6. After raising ￡3, 000m for a secondary capital project investment through corporate bonds at the beginning of 2021, Cooltech PLC’s capital struc- ture is slightly changed, together with its weighted average cost of capital (WACC). Assume that the operation did not affect the market value of the company’s shares. (a) The company’s beta is quoted at β = 1.4, the expected market return for the next period is 3% and the risk-free rate on short-term government se- curities is 0.2%. Calculate the company’s cost of equity capital.[1 mark] (b) The company raised the ￡3, 000m through two bond issues. One issue (A bonds) of zero coupon bonds with total face value ￡2, 000m, maturity 10 years and current total market value of ￡1, 500m. One issue (B bonds) of irredeemable bonds with total face value ￡1, 500m, selling at par and a coupon rate of 2%. The company’s only other debt in issue is another zero coupon bond (C bonds) with a total face value of ￡1, 900m, maturity 5 years and current total market value of ￡1, 600m Calculate the company’s cost of debt assuming a flat corporate tax of 20%. [6 marks] (c) Calculate the company’s WACC. [2 marks] [Question total: 9 marks] 7. Describe the form of a futures contract. Discuss the implications of margin payments for companies which use futures to manage the risks associated with their finances. [5 marks] 8. The directors of a medium sized company are concerned that their gross profit margin and net profit margin are both far lower than the industry average. They have asked for recommendations to improve matters. The company’s chief accountant has responded that the only really important profitability ratio is the return on capital employed (ROCE) and that, as the ROCE is the highest in the industry, the directors should not be too concerned about profit margins. Explain why ROCE might be considered the most important profitability ratio and explain how a company could have a high ROCE despite poor gross and net profit margins. [5 marks] 9 END THIRD YEAR UNDERGRADUATE EXAMS Finance and Financial Reporting JANUARY 2021 SOLUTIONS Question 1 [35 marks, seen similar] (a) 25 marks. Cooltech PLC P&L Sales 10,878 Purchases -3,701 Sales Costs Wages (factory) -24 Stock variation 40 Energy costs -425 Gross Profit 6,768 Research and Development -2,829 Advertising Expenses -140 Admin & Distribution Costs Insurance Expenses -39 Rent -12 Wages (admin and distribution) -90 Factory Depreciation -50 Vehicle Depreciation -40 Machinery Depreciation -700 Audit Fees -15 Business Rates -7 Operating Profit 2,846 Interest paid -54 Finance Costs Interest earned 178 Profit Before Tax 2,970 Tax -174 Tax Costs Net Profit 2,796 [10 marks][-1 for each incorrect allocation] Workings [total marks5]: Factory Depreciation= (500 0) 10 = 50. [1 mark] Vehicle Depreciation: r = 1 ( 20 320 ) 1 4 = 0.5 Vehicle Deprn.=(320 240)× 0.5 = 40. [2 marks] Machinery depreciation= (4950 750) 6 = 700. [1 mark] Rent=Total amount paid – Amount not relevant to the period= 15 3 = 12. [1 mark] Cooltech PLC Statement of Financial Position Non-Current Assets 15,862 Investments 10,092 Factory 500 Vehicles 320 Machinery 4,950 Current Assets 2,378 Cash 1,865 Rent Prepayments 3 Trade Receivables 190 Inventory 320 Balance Equation Equity 12,204 Liabilities 6,036 Assets 18,240 Non-Current Liabilities 4,430 Loan Capital 1,900 Factory Deprn. 150 Vehicles Deprn. 280 Machinery Deprn. 2,100 Current Liabilities 1,606 Dividends Payable 925 Bad Debt Provision 95 Bank Overdraft 10 Trade Payables 402 Tax Accruals 174 Equity 12,204 Capital 9,250 Retained Profits 1,083 Net Profits after tax 2,796 Dividends payable -925 or (taking net asset values) Non-Current Assets 13,332 Investments 10,092 Factory 350 Vehicles 40 Machinery 2,850 Current Assets 2,378 Cash 1,865 Rent Prepayments 3 Trade Receivables 190 Inventory 320 Balance Equation Equity 12,204 Liabilities 3,506 Assets 15,710 Non-Current Liabilities 1,900 Loan Capital 1,900 Current Liabilities 1,606 Dividends Payable 925 Bad Debt Provision 95 Bank Overdraft 10 Trade Payables 402 Tax Accruals 174 Equity 12,204 Capital 9,250 Retained Profits 1,083 Net Profits after tax 2,796 Dividends payable -925 [10 marks][-1 for each incorrect allocation] (b) 10 marks, unseen. Financial Ratio Year 2020 ROA 15% ROE 23% Net Profit Margin 26% Acid Test 1.66 Payables Turnover 34d Inventory Turnover 21d Gearing 13% Asset Cover 8.75 P/E 50.5 Dividend Yield 0.7% or, using depreciated asset values: Financial Ratio Year 2020 ROA 16% ROE 23% Net Profit Margin 26% Acid Test 1.66 Payables Turnover 34d Inventory Turnover 21d Gearing 13% Asset Cover 7.42 P/E 50.5 Dividend Yield 0.7% [1 mark for each correct answer. ] Question 2 [20 marks, unseen] (a) A [2 marks] (b) B [2 marks] (c) C [2 marks] (d) D [2 marks] (e) A [2 marks] (f) B [2 marks] (g) C [2 marks] (h) D [2 marks] (i) D [2 marks] (j) B [2 marks] Total Marks 20 Question 3 [7 marks, unseen] Tax ￡m Profit before tax 2970 +depreciation 790 less capital allowances -650 less tax relief -112 less loss brought forward -2128 taxable profit 870 [-1 for each misallocation/missing item] [6 marks] Now the tax payable is ￡174m so the average tax rate is 174 870 = 20%. [1 mark] Question 4 [10 marks, seen similar] (a) [8 marks] Yield Project NPV PI Discounted Payback Period 10% Project L 89.0 1.09 3.81 years 14% Project L 20.1 0.98 Never [2 marks for NPVs, 1 mark for each other figure/answer] (b) [2 marks] IRR for project L is approximately 10+ 20.1 20.1+89.0 ×4 = 10.7%. Question 5 [9 marks, seen similar] (a) To raise at least￡3000m we require 3.45×9250 n ≥ 3, 000 10.638 ≥ n. So the maximal n satisfies n+1 > 10.638 ≥ n. So the maximal value is 10. [2 marks] (b) [Total 5 marks] (i) Total new shares issued S = 9250 10 = 925m Total capital raised C = S P = 925×￡3.45 = 3, 191.25m Company’s market value before the issueM0 = S0 P0 = ￡15.25× 9250 = ￡141, 062.5m Company’s market value after the issue M1 = M0+C = ￡144, 253.75m Shares outstanding after the issue S1 = S0 + S = 10, 175m. [4 marks] (ii) Theoretical ex-rights share price P1 = ￡15.25×2+￡10.103 = ￡13.53 Rights value per share P = P0 P1 = ￡1.72. [2 marks] (c) The subscription price need to be below the market value of the shares in order to allocate the fresh shares. If the price were higher, no-one would exercise their rights. [1 mark] Question 6 [9 marks, seen similar] (a) Using the CAPM, the company’s cost of equity is given by rE = rf + β (rM rf ) = 0.2 + 1.4× (3 0.2) = 4.12%. [1 mark] (b) [6 marks] The company’s cost of debt: A bonds have a yield of 2000 1500 1 10 1 = 2.92%. [1 mark] B bonds have a yield of 2.00%. [1 mark] C bonds have a yield of 1900 1600 1 5 1 = 3.50%. [1 mark] Total market value of debt is 1,500+1,500+1600=￡ 4,600m, so rD = ￡1500 ￡4600 2.92% + ￡1, 500, 000 ￡4600 2% + ￡1600 ￡4600 3.50% = 2.82% [2 marks] Assuming a flat corporate tax of 20%, cost of debt is equal rD × (1 τ) = 2.26%. [1 mark] (c) Total market value of the company is 15.25×9250 = 141, 062.5m. So the WACC = 4600 4600+141062.5 × 2.26% + 141062.5 4600+141062.5 × 4.12% = 4.06%. [2 marks] Question 7 [2 marks seen, 3 marks unseen]. A futures contract is a standardised, exchange tradable contract be- tween two parties to trade a specified asset on a set date in the future at a specified price. Each party to a futures contract must deposit a sum of money known as margin with the clearing house. Margin payments act as a cush- ion against potential losses which the parties may suffer from future adverse price movements. When the contract is first struck, initial margin is deposited with the clearing house. Additional payments of variation margin are made daily to ensure that the clearing house’s exposure to credit risk is controlled. This exposure can increase af- ter the contract is struck through subsequent adverse price move- ments. [2 marks] [unseen 3 marks] The margin will always be sufficient to settle any liability and so participants can be certain that they will receive everything that they are entitled to at maturity. [1 mark] The margin payments will tie up cash, which could be a problem if a company is an active player in the derivatives markets and has a number of positions outstanding. [1 mark] No interest is paid on this deposit and so there could be a cost to tying up cash. [1 mark] Derivatives can be volatile and so the margin can increase signifi- cantly and unexpectedly. That could lead to difficulties in managing cash flows. [1 mark] Max 3 marks Question 8 [5 marks, unseen]. Return on capital employed is normally re- garded as the most reliable measure of profitability. [1 mark] Given a certain level of investment, it is always better for the business to generate the highest possible return on that capital. A high ROCE demonstrates efficient use of a scarce resource. [1 mark] Other ratios might give an insight into profitability, but they can be difficult to interpret in isolation. [1 mark] Lower profit margins imply that the company makes less profit from every ￡1 of sales. That does not necessarily mean that the com- pany is poorly managed. For example, it could be pricing its sales aggressively in order to increase market share. [1 mark] In spite of the lower net and gross profit the company has a high re- turn on capital employed. This suggests that the company is generat- ing good profits from the capital employed in the company. [1 mark] The capital employed must be relatively lower than others in the industry and is being used effectively. [1 mark] For example, supermarkets generaly have low gross and net profit margins and having particularly low margins while having a high ROCE might be viewed as a real strength. [1 mark] Max 5 marks
