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 2011
Level 2
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
C
A
A
C
B
A
D
A
C
D
C
D
D
B
C
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
B
A
D
D
A
B
A
D
B
B
C
B
B
A
A
31
32
33
34
35
36
37
38
39
40
D
B
C
D
B
C
A
A
B
D
(60 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 - Financial Accounting and Financial Statement Analysis
2(a)
Borrowing cost is defined as interest and other costs incurred by an entity in connection
with the borrowing of funds.
(2 marks)
2(b)
i. Only borrowing costs directly attributable to the acquisition, construction and
production of qualifying assets can be capitalized.
ii. Capitalization of borrowing cost can only commence if expenditure on the asset is
being incurred.
iii. Capitalization of borrowing cost can only commence if borrowing costs are being
incurred.
iv. Capitalization of borrowing cost can only commence if activities are in progress that
are necessary to prepare the asset for its intended use or sale.
v. Capitalization of borrowing cost can only continue if active development is not
interrupted for any extended period.
(1 mark for each point)
= 2 marks
Total = 4 marks
2
Question 3 - Economics and Financial Markets
3(a)
Price discrimination is the practice of selling a specific product at more than one price
when the price differences are not justified by cost differences.
(1 mark)
The enabling conditions are:
i.
Monopoly power: the seller must be a monopolist capable of controlling output or
price.
ii.
Market segregation: The seller must be able to segregate buyers on the basis of
willingness or ability to pay for the product.
iii.
No resale. The original buyer cannot resell the product or service.
(1 mark each for any two points)
= 2 marks
Total = 3 marks
Question 4 - Quantitative Analysis and Statistics
i.
Loan repayment
Some loans are packages as annuity loans wherein the installments are the same
amount throughout the repayment period, assuming the interest rate does not change.
ii.
Pension payment
Annuity is relevant in pension arrangements. For example in a life annuity insurance,
where a life insurance company makes a series of future payments to a buyer
(annuitant) in exchange for the immediate payment of a lump sum, prior to the onset of
the annuity.
(1½ marks for each point)
Total = 3 marks
SECTION C: COMPULSORY QUESTIONS
Question 5 - Financial Accounting and Financial Statement Analysis
5(a)
Profitability
Over the last three years, there has been a sharp drop both in the profit margin on sales
and in total asset turnover of the company. The formal could be attributable to a rise in
production cost and/or expenses, while the latter could be caused by slow growth of
turnover or an increase in total assets. The rise in expenses will probably be attributable
to rising interest charges, since the debt ratio of the company has risen steadily over the
period under consideration. The overall impact of all these was a drastic deterioration in
return on net worth from 31.4% in 2008 to 10.8% in 2010.
(3 marks)
3
Working Capital
Clearly, the company is facing a major crisis in the management of working capital. The
average collection period of debtors has risen by almost 50% in the last three years and
compares very unfavorably with the industrial average. Stock turnover at 1.8 times in
2010, compared with an industry average of 7.0, even more dramatically indicates that
the resources of the business are being tied up in working capital without contributing to
an increase in the level of activity. The working capital position may be a pointer to the
fact that the company is over-trading. It is likely that the company is producing stocks
faster than it could push them out, and at the same time relaxing its credit policy in
order to generate more sales.
(3 marks)
Liquidity
The liquidity position has deteriorated in the last three year. If the trend continues, the
company may find itself in a precarious position where it would find it difficult to meet its
on-going obligations. Current ratio remained at very comfortable levels in 2008 and
2009, only to drop significantly in 2010. An analysis of the quick ratio reveals a similar
trend. This situation is most likely a direct fall out of the deteriorating working capital
position. With resources tied down in stock and debtors, the company is finding it
difficult to generate adequate liquid resources to maintain a healthy liquidity position.
(3 marks)
Gearing
Perhaps to keep business running, and ease the tightening liquidity position, the
company has resulted to increasing its debt. Consequently, debt ratio increased in the
last three years from 22.8% in 2008 to 48.2% in 2010, bringing the ratio to a level
almost at par with the industrial average of 50%. The current position leaves little room
for further borrowing.
(2 marks)
Conclusion
The overall picture given by an analysis of the company‘s ratio over three years is
alarming, with declining profitability, declining liquidity and sharp increase in gearing.
The finance director’s proposal for increased borrowing, presumably to finance an even
higher level of working capital, does not seem appropriate in the light of this analysis.
Instead, the company should be considering ways of reducing its borrowing by tighter
stock control and more prompt collection from debtors. Given that it has been possible
to maintain the fixed asset turnover and the gross profit percentage, the company’s
weaknesses can be identified as lying in the area of working capital control.
(3 marks)
= 14 marks
5(b)
5(b1) Calculation of goodwill
N
Cost of acquisition
Net assets acquired:
6,000,000
Fair value adjustment
500,000
6,500,000
80% thereof acquired
Goodwill
N
10,000,000
(5,200,000)
4,800,000
(4 marks)
4
5(b2)
The Goodwill computed above is positive Goodwill.
(1 mark)
In line with the provisions of IFRS 3, the following guidelines will apply to its treatment.
i.
ii.
iii.
Goodwill acquired in a business combination as above is recognized as an asset
and is initially measured at cost.
After the initial recognition, Goodwill is measured at cost less any accumulated
impairment losses (it is not amortized).
Goodwill is tested for impairment at least annually in accordance with IAS 36.
(3 marks)
= 4 marks
Total = 22 marks
Question 6 - Economics and Financial Markets
Suppose you were a member of the Board of Directors of the Central Bank of Nigeria.
The Nigerian economy is experiencing a sharp and prolonged inflationary trend.
6(a)
The quantity theory of money states that the quantity of money is the main determinant
of the price level. Any change in the quantity of money procedures on exactly
proportionate change in the price level. Expressed mathematically, the theory says:
M.V = P.Y
Where the velocity of circulation (V) is the ratio of nominal income P.Y (prices P times
real income Y) to nominal money M. the proportionate relationship between M and P
rests on assumptions that velocity, V, and Y, real income remain constant.
Hence, in the context of the quantity theory of money, the sharp and prolonged
inflationary trend is possibly the consequence of excessive money supply in the
economy.
(2 marks)
6(b)
In view of the likelihood of excessive money supply prompting this inflationary
trend, the following recommendations could be made.
i. A substantial increase in reserve ratio
ii. A substantial increase in discount rate
iii. Sale of government securities in the open market.
(3 marks)
5
6(c)
By increasing the reserve ratio, the banks are made to create fewer deposits and thus
constrained to undertake less lending than they would really like.
This amounts to limiting their capacity for deposit creation and
consequently a reduction in the size of the money multiplier and money supply in the
economy.
As far as the demand for money remains unchanged the reduction in money supply
arising from the increased reserve ratio will bring about an increase in interest rate.
(4 marks)
The discount rate is the interest rate that the Central Bank charges when the
Commercial banks want to borrow money. By raising the discount rate the central bank
will induce commercial banks voluntarily to hold additional cash reserves since bank
deposits now become a lower multiple of bank’s cash reserves, the money multiplier is
reduced and the money supply is lower for any given level of the monetary base.
The consequence of increased discount rate on interest rate is to raise it because the two
rates move in tandem. Commercial banks ordinarily will change interest rates not lower
than discount rates.
(4 marks)
The excessive money supply in the economy calls for selling financial securities in the
open market. The sale of securities alters the monetary base, in this case reduces it.
Since the money supply is the monetary base multiplied by the money multiplier, a
reduction in the monetary base will result in the reduction of money supply.
By selling financial securities in the open market, prices of financial securities will tend to
fall which amount to an increase in interest rate.
(4 marks)
Total = 17 marks
6
Question 7 - Quantitative Analysis and Statistics
7(a)
Computation of portfolio standard deviation
Given the following variables:
w1
w2
w3
= 32%
= 51%
= 17%
1
=29%
2
=24.7%
3
=27.3%
ρ1,2 =0.361
ρ1,3 =0.317
ρ2,3 =0.548
Insert into the standard deviation formulae for a three asset portfolio:
=
{(0.32)2(0.29)2 + (0.51)2(0.247)2 + (0.17)2(0.273)2
+ 2(0.32)(0.51)(0.361)(0.29)(0.247)
+ 2(0.32)(0.17)(0.317)(0.29)(0.273)
+ 2(0.51)(0.17)(0.548)(0.247)(0.273)}
= 0.210 = 21%
(6 marks)
7(b)
As measured by its standard deviation, the risk of the portfolio in 7(a) is 21%. This is
lower than the risk of the individual stocks: Alpha (29%), Cappa (24.7%) and Gamma
(27.3%).
The implication of the above observation is that it pays to diversify by investing in a
combination of the stocks, thereby reducing the overall risk of the portfolio.
(5 marks)
Total = 11 marks
7