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]