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Describe with an example the circumstances which affect whether bonds are issued at a premium or at a discount

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Question 1
Victoria is a publicly listed company that would like to acquire 100% of a private company to expand
its operations. It has obtained the following draft financial statements for two companies, Grappa
and Merlot. They operate in the same industry and their managements have indicated that they
would be receptive to a takeover.
Statement of income for the year ended 30 September 20X3 Revenue
Cost of sales
Gross profit
Operating expenses
Finance costs - loan
Finance costs - overdraft
Finance costs - lease
Profit before tax
Income tax expense
Profit for the year
Note: Dividends paid during
the year Grappa
$’000
12,000
(10,500)
1,500
(240) Merlot
$’000
20,500
(18,000)
2,500
(500) (210)
0
0
1,050
(150)
900
250 (300)
(10)
(290)
1,400
(400)
1,000
700 Statement of financial position as at 30 September 20X3
Grappa
$’000
4,400
5,000
0 Merlot
$’000
0
2,200
5,300 Non-current assets
Current assets
Inventory 9,400 7,500 2,000 3,600 Trade receivable
Bank
Current assets
Total assets
Equity and liabilities
Equity shares of $1 each
Property revaluation reserve
Retained earnings
Equity 2,400
600
5,000
14,400 3,700
0
7,300
14,800 2,000
900
2,600
5500 2,000
0
800
2800 Non-current assets
Freehold factory [Note (i)]
Owned plant [Note (ii)]
Leased plant [Note (iii)] Page 3 of 10
Examination – January Semester 2016
Non-current liabilities
Finance lease obligations
[Note (iii)]
7% loan notes
10% loan notes
Deferred tax
Government grants
Non-current liabilities
Current liabilities
Bank overdraft
Trade payables
Government grants
Finance lease obligations
[Note(iii)]
Taxation
Current liabilities
Total equity and liabilities 0 3,200 3,000
0
600
1,200
4,800 0
3,000
100
0
6,300 0
3,100
400
0 1,200
3,800
0
500 600
4,100
14,400 200
5,700
14,800 Note:
(i) Both companies operate from similar premises.
(ii) Additional details of the two companies’ plant are: Owned plant - cost
Leased plant - original fair
value Grappa
$’000
8,000
0 Merlot
$’000
10,000
7,500 There were no disposals of plant during the year by either company.
(iii) The interest rate implicit within Merlot’s finance lease is 7.5% per annum. For purpose of
calculating ROCE and gearing, all finance lease obligations are treated as long-term interest bearing
borrowings.
(iv) The following ratios have been calculated for Grappa and can be taken as correct for comparison
with Merlot: Return on year end capital employed (ROCE)
Capital employed taken as shareholders’ funds
plus
Long-term interest bearing, see Note (iii) above
Pre-tax return on equity (ROE)
Net assets (total assets less current liabilities)
turnover
Gross profit margin
Operating profit margin
Current ratio
Closing inventory holding period 14.8% 19.1%
1.2 times
12.5%
10.5%
1.2:1
70 days Trade receivables’ collection period
Trade payables’ payment period (using Cost of
sales)
Gearing [see Note (iii) above)]
Interest cover
Dividend cover 73 days
108 days
35.3%
6 times
3.6 times Page 4 of 10
Semester 2016
Required:
(a) Calculate for Merlot the ratios equivalents to all those given for Grappa above in (iv).
(12 marks)
(b) Assess the relative performance and financial position of Grappa and Merlot for the year ended
30 September 20X3 to inform the directors of Victoria in their acquisition decision.
(8 marks)
(c) Explain the limitation of ratio analysis. Analyse and identify any further information that may be
useful to the directors of Victoria when making an acquisition decision.
(5 marks)
Question 2
This question consists of two parts (Part I and II). You are required to answer both parts.
Part I
Alpha Ltd was incorporated in 20X1, with a paid-up capital of 5,000,000 ordinary shares. Its
accounting year end is 31 December each year.
On 1 October 20X4, Alpha Ltd issued 1,000,000 convertible preference shares (CPS). The CPS carries a
net dividend rate of 7 cents per share (which are payable quarterly) and are convertible into ordinary
shares at a rate of 1:1 as from 1 January 20X5 onwards.
Alpha Ltd profits after tax were $1,000,000 for each of the years ended 31 December 20X4 and 20X5.
Required:
To explain the effects of the above events,
(a) Compute the basic earnings per share for the year 20X4.
(4 marks)
(b) Compute the diluted earnings per share for the year 20X4. (4 marks)
(c) Compute the basic earnings per share for the year 20X5.
(4 marks)
Page 5 of 10
2016
(d) Compute the diluted earnings per share for the year 20X5.
(4 marks)
Part II
In some cases, exercises of options or conversion of securities to shares would lead to an increased
EPS.
Explain briefly a procedure used for an anti-dilution test.
(9 marks)
Question 3
This question consists of two parts (Part I and II). You are required to answer both parts.
Part I
On 1 January 20X0, UVC Limited issued $100,000, 9%, 5 year bonds at a premium of $4,100. It pays
interest semi-annually on 1 January and 1 July. The market interest rate was 8%.
Required:
(a) Write the journal entry to issue the bond on 1 January 20X0.
(3 marks)
(b) Construct the amortization schedule assuming that the effective interest rate is used to amortize
the premium for the years from 1 January 20X0 to 1 January 20X2.
(16 marks)
(c) Write the journal entry for the first interest payment using the effective-interest method to
amortize the premium.
(3 marks)
Part II
Describe with an example the circumstances which affect whether bonds are issued at a premium or
at a discount. Name one reason why issuance of bond at a premium is rare in practical world.
(3 marks)
Page 6 of 10
2016
Question 4 (a) Three factors that are potential sources of noise and bias that may affect the quality of accounting
are (i) manager’s accounting choices; (ii) rigidity in accounting rules; and (iii) random forecast errors.
Comment on how accounting regulation can affect each of those factors and the quality of
accounting.
(9 marks)
(b) List and describe four (4) red flags that would alert an analyst conducting financial statement
analysis. For each red flag, discuss what are some questions that need to be answered by a more
detailed analysis of the company.


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