Papers Chapters 1 - 8 Flashcards
Information asymmetry has been identified as a serious problem for shareholders.
(a) Explain what is meant by “information asymmetry” in the context of limited
companies.
(b) Explain the role of financial reporting as a means of resolving information
asymmetry for shareholders.
(a) Information asymmetry arises because the directors know more about the
management of the company than its shareholders.
The directors can also have
greater confidence in the figures at their disposal because they can check the
underlying data and the manner in which the information has been prepared.
(b) Financial reporting is a vital part of assuring the shareholders that the
company is being managed properly and in their best interests.
The directors
will normally be keen to signal that the figures have been prepared accurately
and in accordance with acknowledged accounting standards. Publishing
credible financial statements will simplify the process of dealing with
shareholders.
The external financial statements are likely to be subject to an independent
external audit to further enhance the credibility of the accounts
Describe the advantages of raising additional equity finance by means of a rights
issue.
A rights issue is targeted at shareholders who have already demonstrated their
willingness to invest in the company. That reduces the cost of promoting the issue and
identifying suitable investors.
If the shareholders do not wish to take up their rights then the rights themselves have
a value and the shareholders have an incentive to sell them. The buyers are likely to
take up the right to subscribe to the offer, which reduces the need to underwrite the
issue.
The fact that the rights issue automatically compensates the shareholders for the
effects of the discount means that it is generally an equitable and acceptable method of generating fresh equity. That makes rights issues more acceptable to the stock
market than other methods for an established company to issue further shares
financial market
A financial market is a broad term that refers to any marketplace where buyers and sellers participate in the trading of financial assets such as stocks, bonds, currencies, commodities, and derivatives
Financial markets are crucial for the economy as they facilitate
the transfer of funds between savers and investors, which in turn promotes economic growth.
The capital market, on the other hand, is a specific type of financial market where long_______
long-term securities, such as stocks and bonds, are bought and sold.
The capital market is where businesses and governments can raise funds by_________. It is also where investors can buy and sell these securities to ___________.
selling securities to investors. It is also where investors can buy and sell these securities to other investors.
Explain why a small business should take great care in managing its overdraft
Overdraft facilities are repayable on demand.
If the facility is not managed properly
then there is a risk that the bank will demand immediate repayment and that could
have severe consequences for the company.
The bank might also use the overdraft
the facility as a means of monitoring the business’s financial health and any excessive
reliance could undermine the business’ credit rating.
It is also undesirable to use
overdrafts extensively because they are very expensive. Using
a short-term loan to replace the overdraft would be preferable. Doing so would also free some of the
overdraft facilities to provide cover for contingencies.
National tax systems often have the objectives that the tax burden is fair and
reasonable. Explain how these objectives are achieved.
Tax systems often focus more heavily on income rather than wealth, which means that
taxpayers are more likely to be asked to pay a tax bill that is based on cash flows
rather than other assets that might not be liquid.
Tax charges are usually levied in
arrears, so that the income has been earned before it is taxed.
Tax systems often
attempt to ensure that income is taxed only once, for example double tax relief
reduces the chances of the same income being taxed by two separate regimes and
similarly imputation systems are often designed to ensure that income tax is not paid
on dividends that are paid out of profits on which corporate tax has been paid.
Tax systems also tend to feature tax-free allowances and also accelerating rates, which
makes them progressive and means that those who can afford to pay at a higher rate
actually do so.
Explain why Eurobonds tend to offer investors a higher rate of return than traditional
loan stock. [5
The main reason for paying a higher rate is that Eurobonds are issued outside of any
legal jurisdiction. That lack of regulation increases the risk to the lender. Eurobonds
tend to be unsecured, which increases the risk even further.
Eurobonds are traded
through banks rather than stock exchanges, which further reduces the scope for
regulation. Eurobonds tend to be used to raise large amounts of money, and so a
higher rate will make it easier to ensure that the issue is taken up
Comment on the suggestion that the interests of shareholders and lenders can conflict
The shareholders enjoy any profits after interest and tax and are keen to see the
company prosper. The lenders wish to have their agreed interest and repayments.
Neither party will necessarily benefit if the other suffers. If the company is unable to
repay its lenders then the shareholders may lose everything. If the company does not
make a profit then it may prove difficult to meet loan repayments.
There is a difference in risks, which could have an impact on the differences between
the shareholders and the lenders. The shareholders enjoy upside risks, whereas there
are no real upside risks for lenders. Thus, lenders may have no incentive to encourage
significant risk-taking on the part of the companies that they lend to. There may be
times when shareholders have very little downside risk. For example, if the company
is in difficulties then the shareholders may feel that there is little to be lost if the
company takes risks in order to deal with the problem. If the company is going to fail
anyway then the risks will cost them nothing if the risky strategies fail but the lenders
may suffer if the funds that would be used to meet their repayments are lost.
Simon established an actuarial practice several years ago. The business has been
successful. One of Simon’s longest-serving actuaries has started to look for
alternative employment and Simon is considering offering her a partnership in the
practice.
Discuss the implications for Simon of making this employee a partner.
Admitting a partner is a serious matter. The new partner will be entitled to an agreed
share of any profits, which could prove expensive to Simon. Simon will also be
jointly and severally liable with the new partner, even if the liabilities arise from an
act or omission on her part.
Presumably the new partner will be expected to buy her way into the equity and that
could generate long term funding for the business.
Granting a partnership should avoid the risk of this person leaving Simon’s practice.
That may be a good enough reason for the partnership in itself if Simon has become
dependent on this individual. She will also be more highly motivated by the fact that
she has a personal stake in this business.
This question was also done well with a number of candidates scoring full marks.
Explain why preference shares are generally accounted for as debt rather than equity.
[5]
Preference shares are only equity in the legal sense of the relationship between the
company and the shareholder. Preference shares carry a fixed dividend, which has
exactly the same impact on the ordinary shareholders’ returns as borrowing. If the
preference dividend is suspended then the rights are likely to be carried forward, so
the dividend will be paid eventually. Shareholders are also likely to have additional
rights in the event that the preference dividend is in arrears.
Historically, preference shares have often been designed to avoid showing debt in the
statement of financial position. It has become important to show them as debt because
that has been the motive for issuing them.
Explain why tax legislation does not permit depreciation as an expense for tax
purposes but grants a capital allowance instead. [5
Depreciation requires highly subjective judgements that can be exploited to manage
the resulting depreciation figure. If depreciation could be charged as an expense then
the company could virtually determine its own tax charge.
Capital allowances are calculated in a consistent manner, so the tax authorities know
exactly what they will be. That avoids the risk that time will have to be spent
checking and evaluating the calculation.
The tax system can also permit the encouragement of investment. For example, the
initial rate can be as high as 100% in the first year, so that there is an additional cash
flow advantage from the tax system.
