CHARTERED INSTITUTE OF STOCKBROKERS
ANSWERS
Examination Paper 2.1
Financial Accounting and Financial Statement Analysis
Economics and Financial Markets
Quantitative Analysis and Statistics
Professional Examination
March 2014
Level 2
SECTION A: SOLUTION MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
A
C
A
A
A
D
D
B
C
B
D
C
B
D
C
C
C
D
B
C
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
A
D
D
D
C
B
B
A
A
C
D
B
D
B
D
A
A
D
A
C
(40 marks)
SECTION B: SOLUTION TO SHORT ANSWER QUESTIONS
Solution to Question 2 - Financial Accounting and Financial Statement Analysis
I.
Increased debt increases the leverage factor in a company.
II.
During normal or boom times, leverage results in exponential profit returns.
III.
During recessions, leverage can result in exponential losses.
IV.
A large debt burden carries risk because of the reaction of leverage to the prevailing
economic conditions.
V.
Increased debt favours ROE during boom times but hurts ROE during recessions.
(3 marks)
Solution to Question 3 - Economics and Financial Markets
Inflation illusion occurs when people confuse nominal changes in inflation with real
changes. People’s welfare depends on real variables, not nominal variables.
(3 marks)
Solution to Question 4 - Quantitative Analysis and Statistics
Present Value, PV = Future Value (FV)
(1 + r)n
where, FV = the future value being expected
r = interest rate per annum
PV = amount to be paid now to yield the future value.
Perpetual Annuity, PV = A/r
PV = N500,000/0.1
PV = N5,000,000
(1 mark)
(2 marks)
It does not make sense to pay more than the present value of all future cash flows from any
investment. Since the PV is N500,000, I should not pay a kobo more than that.
(1 mark)
(4 marks)
SECTION C: SOLUTION TO ESSAY TYPE, CALCULATION AND/OR CASE STUDY QUESTIONS
Solution to Question 5 - Financial Accounting and Financial Statement Analysis
5 (ai)
N’000
N’000
5,000
Sale
Less Cost of Sales:
Opening Inventory
Purchases
400
2,800
3,200
Less Closing Inventory
(350)
(2,850)
Gross Profit
2,150
Less Operating Expenses:
Depreciation
200
Other expenses
600
(800)
Net Operating Profit
1,350
Income Tax (0.3 * 1,350)
(405)
Profit After Tax (PAT)
945
Solution 5 (aii)
Cash flow from operating activities
N’000
Net Operating Profit
Add: Depreciation
N’000
1,350
200
1,550
Changes in working capital:
Reduction in Inventory (400 -350)
50
1,600
Taxation
Cash flow from operating activities
(405)
1,195
(5 marks)
Solution 5(b)
PAT (N)
CASH FLOW FROM OPERATING
ACTIVITIES
ORIGINAL FIGURE
(N)
945,000
1,195,000
(200,000)
0
350,000
(350,000)
From 5(a) above)
TRANSACTION
I
II
0
0
III
______________
500,000
500,000
0
1,000,000
1,595,000
2,345,000
IV
V
REVISED FIGURE
½ mark each for solutions I – V (5 marks)
Solution 5(c1)
i.
The price earnings ratio, computed as:
Share price
Earnings per share
It expresses the relationship between the stock market price of a share and the
earnings after tax and before extraordinary items attributable to that share. Thus,
the analyst can see what multiple of earnings the share price represents.
ii.
The dividend yield, computed as:
Dividend per share
Share price
It expresses the percentage return that an investor in ordinary shares would
currently earn on that investment in the form of dividend.
iii.
The stock turnover ratio can be computed as:
Cost of Sales
Stock
In this case, it represents the number of items stock turns over during the year,
assuming that stock levels do not fluctuate. The ratio may also be computed as:
Turnover
Stock
Since stock is measured at cost, while turnover is measure at selling price, this
ratio is not as useful as one based on cost of sales. Whichever way the ratio is
computed, it expresses the relationship between the quantity of stock held and
the level of activity.
iv.
Pre-tax return on capital employed, computed as:
Pre-tax return
Capital
It expresses the relationship between the profit earned by a business and the
resources it employs.
(4 marks)
Solution 5(c2)
i.
The price earnings (P/E) ratio indicates that investors in the Foods & Beverages
industry value the ‘earnings’ of those companies more highly than investors in the
building-materials industry; this in turn suggests that the stock market has more
confidence in the future prospects of Foods & Beverages.
ii.
The lower dividend yield in Foods & Beverages appears to be attributable to two
factors:
(a) Share price in the industry are higher relative to earnings.
(b) The industry is distributing a lower proportion of earnings as dividends. This
may well be because there are better prospects in that industry, and therefore
better opportunities to employ retained profit. This view is supported both by
the P/E ratio and the return on capital employed.
iii.
Stock turnover in Foods & Beverages is very much faster than in the buildingmaterials industry. We would expect this because:
(a) Foods & Beverages involves many perishable products, which cannot be held for
long periods of time.
(b) Foods & Beverages sales are likely to occur at an even and reasonably predictable
rate. By contrast, building materials cover a wide range of product lines with a
less even and predictable pattern of demand.
Differing rates of stock turnover are, therefore, to be expected and tell us nothing about
the current state of the industry.
iv.
The pre-tax return on capital employed is comparable between industries, and in
this case indicates that currently the Foods & Beverages industry is operating
more profitably than the building materials industry.
The building-materials industry is subject to greater fluctuations in demand over
the years, and it would seem likely that at the time when these industrial
averages were computed the industry was in a relatively depressed state.
(6 marks)
Solution to Question 6 - Economics and Financial Markets
Solution to 6(a) Economic Recession and Economic Depression
 Economic recession is a period of decline in total output, income, employment,
and trade, lasting six (6) months or longer.
 It is a period of downturn marked by widespread contraction of business in many
sectors of the economy.
 However, because many prices are downwardly inflexible, the price level is likely
to fall only if the recession is severe and prolonged – i.e., if a depression occurs.
Hence, economic depression could be described as the trough of recession.
R
D
D = Depression and R = Recession
 It is the phase in which output and employment ’’ bottom out ’’ at their lowest
levels.
(5 marks)
Solution 6(b) Inflation and Economic Recession
 Inflation is a period of rising general prices on a sustained basis.
 Ordinarily inflation and recession could be considered to be mutually exclusive
meaning you could not have one when the other was occurring. This was the
popular notion in the decades following World War II – having support in the
Keynesian macroeconomic theory.
 However, history has proven this to be incorrect. This has led to the introduction
of the term ’’ stagflation ’’. Stagflation is said to be occurring when the inflation
rate is high with a slowing economy and high unemployment.
 Thus, inflation with a stagnant economy or deep recession/depression could be a
reality, arising for instance from a disruption in the supply chain resulting in
higher prices and lower production.
(2 marks each for any 3 points = 6 marks)
Solution 6(c)
IS-LM Model
L
LM
L2
L1
IS2
IS1
y1
y2
Y
i.
An increase in public expenditure shifts the IS curve rightward from IS1 to IS2 as
in the above diagram.
ii.
This results in increase in National Income (Y), that is, expansion in the real
economy from y1 to y2 and increase in interest rate from L1 to L2 .
iii.
The resulting increase in interest rate can lead to "crowding out", in which case
there is a subsequent reduction in private spending (investment). Thus, the effect
of the stimulus could be offset by the effect of crowding out.
(7 marks)
Solution to Question 7 - Quantitative Analysis and Statistics
Solution 7(a)
Using Venn Diagram,
A
S
a
b
c
d = 0.3
Given,
probability of an Accountant, a + b = 0.4
----------------- (i)
probability of a Stockbroker,
b + c = 0.5
----------------- (ii)
Universal probability,
a + b + c + 0.3 = 1
------- (iii)
Substitute equation (i) in equation (iii),
0.4 + c + 0.3 = 1
c = 1 - 0.3 - 0.4
c = 0.3
From equation (ii),
b + c = 0.5
b = 0.5 - c
b = 0.5 - 0.3
b = 0.2
Therefore, the probability that the man is both an accountant and stockbroker is the
intersection, 'b', which is 0.2.
(4 marks)
Solution 7(b1)
Profit is maximized where marginal revenue (MR) equals marginal cost (Mt)
Revenue, R
= 920q – 8q2
Marginal Revenue, MR = δR/δq
= 920 – 16q
(1 mark)
Cost, C
Marginal Cost, MC = δc/δq
= q2 + 20q + 60
= 2q + 20
For maximum profit,
Marginal Revenue, MR = Marginal Cost, MC
That is,
920 – 16q = 2q + 20
(1 mark)
(1 mark)
-16q – 2q = 20 – 920
-18q = -900
Quantity to be sold, q = 900/18
= 50 units
(1 mark)
(4 marks)
Solution 7(b2)
= 920q – 8q2
= 920(50) – 8(50)2 = N26,000
If 50 units will be sold,
Selling Price, SP = N26,000/50 = N530
Revenue, R
(2 marks)
Solution 7(b3)
Profit = Revenue – Cost
Cost, C
= q2 + 20q + 60
= 502 + 20(50) + 60 = N3,560
Therefore,
Maximum Profit = N26,000 – N3,560
= N22,440
(2 marks)
(12 marks)