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Press release from Marketwire

Deans Knight Income Corporation Releases Interim Financial Statements and Management Report of Fund Performance for the Period Ended June 30, 2010

Thursday, August 12, 2010

Deans Knight Income Corporation Releases Interim Financial Statements and Management Report of Fund Performance for the Period Ended June 30, 201020:12 EDT Thursday, August 12, 2010VANCOUVER, BRITISH COLUMBIA--(Marketwire - Aug. 12, 2010) - Deans Knight Income Corporation (the "Company") (TSX:DNC) is pleased to release its interim Financial Statements and Management Report of Fund Performance for the period ended June 30, 2010.These documents can be found on SEDAR at www.sedar.com or the Company's website: www.dkincomecorp.com.Forward-Looking StatementsThis press release contains forward-looking statements. More particularly, this press release contains forward-looking statements concerning the Company's corporate objectives, the investment of the Company's proceeds from the sale of investments previously made, availability of tax losses and deductions, the anticipated total return to the Company's shareholders and the Company's intention to pay out earned income in the form of monthly dividends. Although the Company believes that the expectations reflected in these forward-looking statements are reasonable, undue reliance should not be placed on them because the Company can give no assurance that they will prove to be correct since forward-looking statements address future events and conditions and by their very nature, involve inherent risks and uncertainties. The forward-looking statements contained in this press release are made as of the date hereof and the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise, unless so required by applicable securities laws.Deans Knight Income CorporationInterim Management Report of Fund PerformanceFor the period from January 1, 2010 to June 30, 2010This interim management report of fund performance (the "Report") contains financial highlights of Deans Knight Income Corporation (the "Company"). This Report should be read in conjunction with the interim financial statements of the Company for the six month period ending June 30, 2010 (the "Financial Statements"), which, if not included with this Report, can be obtained at your request, at no cost by emailing info@dkincomecorp.com , visiting our website at www.dkincomecorp.com for contact details or on SEDAR at www.sedar.com. Shareholders may also contact us to request a free copy of the Company's proxy voting policies and procedures, proxy voting disclosure record or quarterly portfolio disclosure.A Note on Forward-Looking StatementsThis Report contains certain forward-looking statements. These statements relate to future events or future performance, including the Company's targeted dividend payout, investment strategy, behaviour of financial markets and reflect the Company's expectations regarding the growth, results of operations, performance and business prospects and opportunities of the Company and its investments. Such forward-looking statements reflect the Company's current beliefs and are based on information currently available to the Company. In some cases, forward-looking statements can be identified by terminology such as "may", "will", "should", "expect", "plan", "anticipate", "believe", "estimate", "predict", "potential", "continue" or the negative of these terms or other comparable terminology. With respect to such forward-looking statements, the Company has made assumptions regarding, among other things, what type of debt securities will be included in its investment portfolio. A number of factors could cause actual events or results to differ materially from the results discussed in the forward-looking statements. In evaluating these statements, prospective investors should specifically consider various factors, including the risks outlined under "Risk Factors" in the Prospectus (as defined herein), which may cause actual results to differ materially from any forward-looking statement. Although the forward-looking statements contained in the Prospectus are based upon what the Company believes to be reasonable assumptions, the Company cannot assure investors that actual results will be consistent with these forward-looking statements. Forward-looking statements are made as of the date of this Report and, other than as required by applicable law, the Company assumes no obligation to update or revise them to reflect new events or circumstances. This Report also contains certain financial and operational information obtained from public sources in respect of certain companies included in the Company's investment portfolio. While management believes this data to be reliable, such information is subject to variations and cannot be verified due to limits on the availability and reliability of data inputs, the nature of the data gathering process and other limitations and uncertainties inherent in such information. Accordingly, the accuracy, currency and completeness of this information cannot be guaranteed. The Company has not independently verified any of the data from third party sources referred to in this Report or ascertained the underlying assumptions relied upon by such sources.Investment Objective and StrategiesThe Company is a closed-end, non-redeemable investment company focused on investing in corporate debt securities. The Company's assets are actively managed by Deans Knight Capital Management Ltd. ("Deans Knight"), a respected British Columbia-based investment firm focused on managing high income and growth mandates for high net worth individuals. Deans Knight, formed in 1992, has an experienced management team and a long history of successful investing in corporate debt securities.The Company's investment objectives are to: (i) maximize the total return for Shareholders, consisting of dividend income and capital appreciation; and (ii) provide Shareholders (as defined herein) with monthly dividends, which have, to date, been set at $0.0583 per month. The Company intends to achieve these objectives by investing primarily in corporate debt securities rated BBB or below by Standard & Poor's Rating Services ("S&P") or an equivalent rating by another nationally recognized statistical rating organization. The Company may also invest in investment grade debt securities rated above BBB and non-rated debt securities from time to time.The Company believes there are attractive investment opportunities today in owning corporate debt of businesses with tangible assets, strong cash flows and reasonable leverage.When evaluating bonds to purchase for the Company, Deans Knight focuses on the following:- amount of security or collateral within a business to offset the value of the bonds;- the position of the debt in the capital structure;- covenants;- liquidity;- the business's ability to reduce or refinance the debt; and- the overall term of the debt and yield to bondholders.Deans Knight employs the above credit-based analysis to identify corporate debt for inclusion in the Company's investment portfolio with attractive valuations in order to maintain its targeted dividend payment.RiskThe overall risks of the Company are as described in its prospectus dated March 9, 2009 (the "Prospectus"). The Company does not believe there have been any changes over the financial period that has affected the overall level of risk associated with an investment in the Company.Prior to the reorganization and change in business, as discussed in the notes of the Financial Statements, the Company had generated significant tax losses and other tax attributes as a result of its prior businesses and research activities. The Company has recorded, as a tax asset, the full amount of the potential tax benefit of such items to the extent of its projected taxable income. There is no guarantee that the tax authorities will allow the Company to deduct some or all of the tax losses and other attributes. Should the Company be denied the deductions, the recorded amount of the tax assets, as well as such amounts claimed to date, would be recorded as a charge to income. The total tax assets recognized and tax losses and other attributes claimed to date, which are subject to uncertainty, amount to $17,290,000, representing $1.64 per common share at June 30, 2010.Given the type of investments made by the Company, an investment in the Company may be considered to be speculative. An investment in the Company is generally suitable for investors who are looking to receive income, yet who are willing to tolerate volatility in the value of their investment.Results of OperationsAs per the financial statements, the net assets of the Company at June 30, 2010 were $133,437,442, or $12.66 per common share, compared to $128,681,694, or $12.21 per common share at December 31, 2009. The net assets of the Company consisted of the following components: June 30, 2010 ------------------------------------------- Per common $ share(1) % Investments(2) 122,604,003 11.63 91.9 Cash and short-term deposits 2,597,979 0.24 1.9 Accrued income 2,740,660 0.26 2.1 Prepaid expenses 167,619 0.02 0.1 Future income tax asset(3) 6,010,000 0.57 4.5 Accounts payable and accrued liabilities (682,819) (0.06) (0.5) ------------------------------------------- 133,437,442 12.66 100.0 ------------------------------------------- ------------------------------------------- 1. Based on 10,537,263 common shares, including 10,191,592 voting common shares and 345,671 non-voting common shares, as outlined in the notes to the Financial Statements. 2. The details of the investments are outlined in the Summary of Investment Portfolio below. 3. Refer to the Taxation note to the Financial Statements for more detail. December 31, 2009 ------------------------------------------- Per common $ share(1) % Investments(2) 113,245,040 10.74 87.9 Cash and short-term deposits 6,042,756 0.57 4.7 Accrued income 1,670,248 0.16 1.3 Prepaid expenses 89,840 0.01 0.1 Future income tax asset(3) 8,200,000 0.78 6.4 Accounts payable and accrued liabilities (566,190) (0.05) (0.4) ------------------------------------------- 128,681,694 12.21 100.0 ------------------------------------------- ------------------------------------------- 1. Based on 10,537,263 common shares, including 10,191,592 voting common shares and 345,671 non-voting common shares, as outlined in the notes to the Financial Statements. 2. The details of the investments are outlined in the Summary of Investment Portfolio below. 3. Refer to the Taxation note to the Financial Statements for more detail. The increase in the net assets of the Company over the past six months was in large part due to our holding in Whitecap Resources Inc., a private oil and gas producer (9.7% of the Company's net asset value). In August last year, Deans Knight invested $7.5 million in an 8% convertible debenture, which formed part of Whitecap's seed capital, along with a $36 million equity issue. With this capital, Whitecap acquired an asset producing 900 barrels of oil equivalent per day ("boepd') (50% oil and 50% natural gas). On June 1st, 2010, Whitecap announced an agreement to merge with Spitfire Energy Ltd., a public oil and gas producer with assets in Saskatchewan. The combined entity is expected to have production of 1,360 boepd, half of which is oil, in two core areas, with 7 million barrels of oil equivalent ("BOE") of reserves and $15 million in net debt. The merged company will be run by Grant Fagerheim and his team, who have successfully run other junior oil and gas companies, including Ketch Energy, Ketch Resources and Cadence Energy. With the completion of the merger on June 25th, Whitecap's share price rose significantly, resulting in the value of our convertible debenture increasing by 72%, which provided a 4% return to Deans Knight Income Corporation during the period.To view the Credit Spread History chart, please visit the following link: http://media3.marketwire.com/docs/812dnc_1.pdfAs noted in the graph above, credit spreads widened during the period. This should not be a surprise, given investors exposure to the mainstream media which appears to be putting negative connotations on most economic matters. Examples include the collapse of the Euro, the sovereign debt crisis in Europe, the faltering global economic recovery, massive government deficits, the economic threat of the withdrawal of government stimulus, and others.A positive factor in respect of the media's current portrayal of economic unrest is that the worst case scenario can be predicted. It is when the worst case scenario is not predictable that trouble is often just around the corner. For example, prior to the 2008/2009 downturn in the markets, the media had hyped nothing but good news until the financial crisis/recession. This caused investors to forget about risk and made bond (yields) expensive.Regardless of the macro environment, as a bondholder we are only concerned that a business can service its debt and that it has the ability to repay or refinance the debt when it becomes due. The Company is not attempting to belittle the economic challenges ahead. There are many of them, and some may be monumental; however, earnings are improving. In most cases, the investee companies' balance sheets are in better shape than they were 18 months go and the average yield on the Company's holdings is twice that of investment grade onds, and 3 times 5-year government bonds.To view the Bonds chart, please visit the following link: http://media3.marketwire.com/docs/812dnc_2.pdfTo give you an idea of the types of companies we are invested in, we are including some brief comments on our major bond holdings.Paramount Resources 8.5% due January 31, 2013. Paramount is an oil and gas producer with assets in Alberta, Northwest Territories, and North Dakota. Paramount is currently producing 13,500 boepd which is predominantly natural gas. In addition to its producing assets, the bonds are secured by their holding in Trilogy Energy Corp which is currently worth $240 million. Paramount has a current market cap of $1.4 billion with only $90 million in debt.North American Energy Partners (NAEP) 9.125% due April 7, 2017. NAEP provides a wide range of heavy construction and mining, piling and pipeline installation services to customers in the Canadian oil sands, mineral mining, commercial and public construction and conventional oil and gas markets. NAEP's EBITDA to year end March 31, 2010 was $120 million and has net debt of $180 million.Despite the low debt level, NAEP has only a B credit rating due to the perceived cyclical nature of their cash flows. As a result, NAEP has to pay a high coupon and adhere to stricter covenants protecting the bondholders. Although a portion of their business is cyclical, NAEP has a strong management team, with a core oil sands business generating recurring cash flows sufficient to service its debt.MetroPCS Wireless Inc. 9.25% due November 1, 2014. MetroPCS is a wireless communications provider servicing many of the major markets in the US. MetroPCS has $3.6 billion in debt and generated $900 million in EBITDA last year, which should grow as MetroPCS gains more traction in their new markets, being Boston, Los Angeles and New York. Given that MetroPCS has already spent the majority of the capex required to achieve their growth targets, the Company believes that the debt multiples of MetroPCS should decrease over the next few years. In addition, MetroPCS has a strong cash position of $1.1 billion, which could be used for further growth in new markets or to reduce debt.During the six months ended June 30, 2010, the Company continued to make monthly dividend payments of $0.0583 per share to holders of voting common shares and non-voting common shares (collectively, the "Shareholders"), resulting in total dividend payments in the six month period of $0.35 per share. On July 7, 2010, the Company announced that it intends to maintain monthly cash dividends at $0.0583 per share for the three months ended September 30, 2010.Recent DevelopmentsComparison of net asset value and net assetsNational Instrument 81-106 ("NI 81-106") permits investment companies to have two different net asset values: (i) one for financial statements, which will be prepared in accordance with Canadian Generally Accepted Accounting Principles ("GAAP") including Section 3855 (and referred to as "net assets", previously disclosed as "GAAP Net Assets"); and (ii) another for all other purposes, including unit pricing for investor transactions (referred to as "net asset value", previously referred to as "Pricing NAV"). The main difference in calculating net assets and net asset value is that GAAP requires bid price to be used in valuing securities traded in an active market where quoted prices are readily and regularly available, rather than the use of a price between the bid and the ask price currently used for determining net asset value. This difference results in an insignificant difference of approximately $0.05 per common share at June 30, 2010, as outlined in the notes to the Financial Statements.International Financial Reporting StandardsThe Company is required to adopt international financial reporting standards (IFRS). The Canadian Accounting Standards Board (AcSB) previously announced January 1, 2011 as the date international financial reporting standards (IFRS) will replace current Canadian standards and interpretations as GAAP for publicly accountable enterprises, which include investment companies.However, the AcSB recently issued an exposure draft of proposed accounting standard to defer IFRS for investment companies currently applying Accounting Guideline 18 - Investment Companies until years beginning on or after January 1, 2012.Under this exposure draft, the Company's first set of financial statements to be reported on under IFRS will be for the semi-annual period ending June 30, 2012. These statements will include corresponding comparative financial information for 2011, including an opening statement of net assets as at January 1, 2011.The Company has established a transition plan to ensure that it is able to meet its reporting requirements. The plan consists of three main elements, which include:- Identifying differences between the current accounting policies of the Company, which reflect current Canadian GAAP, and those expected to apply under IFRS and the likely financial statement impact resulting from the adoption of IFRS;- Analyzing the impact of the adoption of IFRS on business and reporting processes;- Disclosing the qualitative impact in the December 31, 2009 management report of fund performance and disclosing the quantitative impact, if any, in the December 31, 2010 management report of fund performance.Based on the Company's analysis of current accounting policies and presentation under GAAP against IFRS the adoption of IFRS is not expected to have a material effect on the Company's net assets or net assets per share. The primary impact will be in the areas of presentation and note disclosure. Further, the Company does not believe that the changeover to IFRS will materially affect the Company's existing business arrangements.However, it should be noted that there are additional changes to IFRS expected during the remainder of 2010 and in 2011. This potential for change creates some uncertainty regarding the expected accounting standards that will be upon the Company adopting IFRS. As such, the Company cannot conclusively determine the impact that the adoption of IFRS will have.Throughout the balance of 2010 and in 2011, the Company will continue to monitor new standards and recommendations as they are issued by both the International Accounting Standards Board, who is responsible for the development and publication of IFRS, and the AcSB, to update its analysis as appropriate. By the fourth quarter of the year predating the required adoption, the Company expects to complete its analysis, determine overall financial statement presentation, and complete its assessment. Any changes required with respect to its business arrangements will then be adopted.Harmonized Sales TaxOn July 1, 2010, British Columbia and Ontario provincial sales taxes (PST) were replaced with a value-added tax and combined with the federal Goods and Services Tax (GST) to create a Harmonized Sales Tax (HST). The HST has a combined rate of 12% and 13% in British Columbia and Ontario, respectively. of which the provincial portion will be 7% and 8%, respectively, and the federal portion will be 5%. Although management fees and certain other service costs of the Company are currently subject to the 5% GST, but not PST, these services will be subject to the new HST. Since the Company is not able to recover this tax, the 8% difference will represent an additional cost to the Company.Related Party TransactionsThe officers, and certain directors, of the Company are also employees of the Investment Advisor, Deans Knight Capital Management Ltd. These officers, and directors, are not paid by the Company. Deans Knight provides investment management services to the Company, as well as administration, financial reporting and other ancillary services required by a publicly listed company. Management fees, for the services outlined above, are computed and paid quarterly, at an annual rate of 1.5% of the net asset value plus applicable taxes, and adjusted for certain non-investment related assets.For the six month period ended June 30, 2010, management fees totaled $980,755 (2009 - $424,864). In calculating the amount, the net asset value was reduced by the value of the future income tax asset included in the statement of net assets.A director of the Company is a partner at a law firm that provides legal services to the Corporation. During the six month period ended June 30, 2010, the Corporation incurred $17,409 (2009 - $330,000) in legal services and disbursements received from this related party. At June 30, 2010, accounts payable and accrued liabilities include $ nil (2009 - $10,000) to the law firm for legal fees and disbursements, which have not been billed.Financial HighlightsThe following tables show selected key financial information about the Company and are intended to help you understand the Company's financial performance since it began operating its new business of investing in corporate debt in March 2009. The Company's Net Assets per Common Share (1) Six months Year ended ended December 31, June 30, 2010 2009 $ $ ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- Net assets, beginning of period (2)(3) 12.23 9.12 Increase (decrease) from operations Total revenue 0.49 0.62 Total expenses (0.13) (0.20) Realized gains (losses) for the period 0.28 1.25 Unrealized gains (losses) for the period 0.40 1.23 Recovery of future income taxes (0.21) 0.62 ---------------------------------------------------------------------------- Total increase (decrease) from operations (3) 0.83 3.52 ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- Dividends (3)(4) From income (0.35) (0.41) ---------------------------------------------------------------------------- Net assets at end of period (5) 12.71 12.23 ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- (1) The information is derived from the Company's audited annual and unaudited interim financial statements. Common shares outstanding are 10,537,263, including 10,191,592 voting common shares and 345,671 non-voting common shares. (2) Net assets, beginning of the period for the year ended December 31, 2009 reflect the net assets in the Company at March 17, 2009, after giving effect to the conversion of the Convertible Debenture and interest owing thereon and the issuance of common shares on the IPO less total share issue expenses. (3) Net assets and dividends are based on the actual number of shares outstanding at the relevant time. The increase/decrease from operations is based on the weighted average number of shares outstanding over the period from the date the Company began operating its new business to December 31, 2009. (4) Dividends were paid in cash. (5) The net assets per share presented in the financial statements differs from the net asset value per share calculated for fund pricing purposes due to the provisions of CICA Handbook Section 3855. An explanation of the differences can be found in the notes to the financial statements. Ratios and Supplemental Data 2010 2009 $ $ ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- Net asset value (000's) 133,996 $ 128,930 Number of common shares outstanding (000's) 10,537 10,537 Management expense ratio (2) (3) 1.02% 5.51% Portfolio turnover rate (4) 19.4% 36.69% Trading expense ratio (5) 0.00% 0.01% Net asset value per common share $12.71 $12.23 Closing market price - common share $11.00 $11.40 (1) This information is provided as at December 31, 2009 (2) Management expense ratio is based on total expenses for the period and is expressed as an percentage of weekly average net asset values over the period. For 2009, this ratio is calculated from the date the Company began operating its business as an investment fund, on March 17, 2009, to December 31, 2009. (3) The Management expense ratio for 2009 includes offering costs for the IPO of $6,268,800 less the offsetting related future tax benefit of $1,692,500. (4) The Company's portfolio turnover rate indicates how actively the Company manages its portfolio investments. A portfolio turnover rate of 100% is equivalent to the Company buying and selling all of the securities in its portfolio once in the course of the year. The higher a portfolio turnover-rate in a year, the greater the trading costs payable by the Company in the year. There is not necessarily a relationship between a high turnover rate and the performance of the investment portfolio. (5) The trading expense ratio represents total commissions and other portfolio transaction costs expressed as an annualized percentage of daily average net asset value during the period. This expense is $10,050, as the purchasing and selling of bonds do not attract a commission from the buying or selling party. Management FeesDeans Knight provides investment management services to the Company, as well as administration, financial reporting and other ancillary services required by a publicly listed company. Management fees are computed and paid quarterly, at an annual rate of 1.5% of the net asset value plus applicable taxes, and adjusted for certain non-investment related assets.Past PerformanceThis section shows the Company's past performance, since it began operating its business as an investment fund. The past performance information includes changes in net asset value and assumes the reinvestment of all dividends paid to common shareholders. It is important to note that the past performance will not necessarily indicate what performance in the future will be.Year-by-year ReturnsThe accompanying bar chart shows the Company's performance for the periods shown and illustrates how the Company's performance has changed from period to period. The bar chart shows, in percentage terms, how much an investment made when it began its operation as an investment fund, March 17, 2009 to December 31, 2009 and how much an investment made for the six month period ending June 30, 2010.To view the Year-by-year Returns graph, please visit the following link: http://media3.marketwire.com/docs/812dnc_3.pdf Summary of Investment Portfolio ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- Top 25 investments % of Net asset value Whitecap Resources 8.0% 09-30 -2012 9.7 Paramount Resources 8.5% 01-31-2013 6.6 North America Energy 9.125% 04-07-2017 6.0 Calfrac Holdings LP 7.75% 02-15-2015 5.5 Teck Resources Ltd. 10.75% 05-15-2019 5.3 CCS Inc. 11.0% 11-15-2015 5.2 Trinidad Drilling 7.75% 07-31-2012 4.9 MetroPCS Wireless 9.25% 11-01-2014 4.4 Harvest Operations 7.875% 10-15-2011 4.4 Bombardier Inc. 8.0% 11-15-2014 4.3 Dollarama Group LP FRN 08-15-2012 4.2 Harvest Energy 7.25% 09-30 -2013 4.2 Cott Beverages Inc. 8.375% 11-15-2017 3.5 Methanex Corp. 8.75% 08-15-2012 3.1 Sherritt International Corp. 7.75% 10-15-2015 2.7 Beazer Homes USA 9.125% 06-15-2018 2.4 Pacific Rubiales 8.75% 11-10-2016 2.1 Western Areas NL 8.0% 07-02-2012 2.1 Garda World Security 9.75% 03-15-2017 1.9 Gibson Energy ULC 11.75% 05-27-2014 1.7 McMoRan Exploration 11.875% 11-15-2014 1.6 FMG FIN PTY LTD 10.62% 09-01-2016 1.5 Opti Canada Inc. 7.875% 12-15-2014 1.4 MetroPCS Wireless AC4 9.25% 11-01-2014 1.2 West Fraser Timber 5.2% 10-15-2014 0.9 ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- Portfolio composition % of Net asset value Fixed Income Canadian denominated in CAD 11.6 Canadian denominated in USD 40.0 United States denominated in USD 19.0 Other Foreign denominated in USD 1.5 Other Foreign denominated in AUD 2.1 ------------ 74.2 ------------ Convertible Debentures Canadian denominated in CAD 18.7 Other Foreign denominated in AUD 0.0 ------------ 18.8 ------------ Investment Portfolio 93.0 Cash & short-term deposits 1.9 Other assets less liabilities 5.1 ------------ 100.0 ------------ ------------ Sector Breakdown Energy 53.8 Materials and metals 12.6 Consumer goods 9.5 Industrial/Manufacturing 6.7 Telecommunications 5.6 Chemicals 3.9 Forestry 0.9 ------------ Investment Portfolio 93.0 Cash and short-term deposits 1.9 Other net assets 5.1 ------------ 100.0 ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- Deans Knight Income CorporationFinancial Statements(Unaudited)June 30, 2010NOTICE OF NO AUDITOR REVIEW OF INTERIM FINANCIAL STATEMENTSSection 4.3(3)(a) of National Instrument 51-102, Continuous Disclosure Obligations, provides that if an auditor has not performed a review of the interim financial statements, the interim financial statements must be accompanied by a notice indicating that the financial statements have not been reviewed by an auditor.The Company's external auditors, PricewaterhouseCoopers LLP, have not performed a review of these interim financial statements of Deans Knight Income Corporation.These interim financial statements should be read in conjunction with the most recent annual financial statements. Deans Knight Income Corporation Statement of Net Assets (Unaudited) ---------------------------------------------------------------------------- June 30, December 31, 2010 2009 $ $ Assets Current assets Investments - at fair value (cost - June 30, 2010 - $106,061,337 ; December 31, 2009 - $100,510,397) 122,604,003 113,245,040 Cash and short-term deposits 2,597,979 6,042,756 Accrued interest receivable 2,740,660 1,670,248 Prepaid expenses 167,619 89,840 Future income tax benefits (note 8) 2,358,000 2,210,000 ------------------------------ 130,468,261 123,257,884 Non-current Future income tax benefits (note 8) 3,652,000 5,990,000 ------------------------------ 134,120,261 129,247,884 ------------------------------ ------------------------------ Liabilities Accounts payable and accrued liabilities (note 6) 682,819 566,190 ------------------------------ Net assets 133,437,442 128,681,694 ------------------------------ ------------------------------ Shareholders' Equity Common shares (note 4) 99,366,429 99,366,429 Contributed surplus (note 4) 9,904,504 9,904,504 Retained earnings (note 5) 24,166,509 19,410,761 ------------------------------ 133,437,442 128,681,694 ------------------------------ ------------------------------ Number of common shares outstanding (note 4) 10,537,263 10,537,263 ------------------------------ ------------------------------ Net assets per common share (notes 8 and 12) 12.66 12.21 ------------------------------ ------------------------------ Contingencies (notes 2 and 8) Commitment (note 11) Subsequent Events (note 13) The accompanying notes are an integral part of these financial statements. Deans Knight Income Corporation Statement of Operations Six-month period ended June 30 (Unaudited) ---------------------------------------------------------------------------- 2010 2009 $ $ Investment Income Interest and other 5,142,007 1,725,068 ------------------------------ Expenses Management fees (note 6) 980,755 424,864 Directors' fees and expenses 84,535 53,260 Audit fees 53,384 25,000 Public company reporting costs 72,699 24,418 Foreign exchange loss (gain) 105,965 (32,249) Custodial fees 15,408 12,891 Legal fees 17,409 10,000 Independent Review Committee fees 4,500 - Transaction costs - 10,050 Accretion on convertible debenture (note 4) - 103,730 Interest on convertible debenture (note 4) - 215,213 ------------------------------ 1,334,655 847,177 ------------------------------ Net investment income 3,807,352 877,891 ------------------------------ Realized and unrealized gains (losses) on investments Net realized gain on investments sold (note 7) 2,572,267 953,429 Net realized gain on settlement of foreign currency contracts (note 7) 444,042 3,936,637 Change in unrealized appreciation on investments 5,246,375 10,943,081 Unrealized depreciation on foreign currency contracts (1,438,353) (2,470,292) ------------------------------ Net gain on investments 6,824,331 13,362,855 ------------------------------ Increase in net assets from operations before tax 10,631,683 14,240,746 (Provision for) recovery of future income tax (note 8) (2,190,000) 9,372,500 ------------------------------ Increase in net assets from operations 8,441,683 23,613,246 ------------------------------ ------------------------------ Increase in net assets from operations per weighted average common share (note 3) 0.80 3.87 ------------------------------ ------------------------------ The accompanying notes are an integral part of these financial statements. Deans Knight Income Corporation Statement of Changes in Net Assets Six-month period ended June 30 (Unaudited) ---------------------------------------------------------------------------- 2010 2009 $ $ Increase in net assets from operations 8,441,683 23,613,246 ------------------------------ Dividends to common shareholders from net investment income (3,685,935) (614,322) ------------------------------ Shareholder transactions (note 4) Issuance of common shares on conversion of debenture - 3,358,615 Conversion of equity component of convertible debenture - (398,615) Issuance of common shares for payment of interest on convertible debenture - 215,213 Issuance of common shares on initial public offering, net of offering costs - 95,853,678 ------------------------------ - 99,028,891 ------------------------------ Increase in net assets during the period 4,755,748 122,027,815 Net assets (liabilities) - Beginning of period 128,681,694 (2,856,270) ------------------------------ Net assets - End of period 133,437,442 119,171,545 ------------------------------ ------------------------------ Deans Knight Income Corporation Statement of Cash Flows Six-month period ended June 30 (Unaudited) ---------------------------------------------------------------------------- 2010 2009 $ $ Cash flows from operating activities Increase in net assets from operations 8,441,683 23,613,246 Items not affecting cash Net realized gain on investments sold (2,572,267) (953,429) Net realized gain on settlement of foreign currency contracts (444,042) (3,936,637) Change in unrealized appreciation in value of investments (5,246,375) (10,943,081) Unrealized depreciation on foreign exchange contracts 1,438,353 2,470,292 Accretion on convertible debenture - 103,730 Interest on convertible debenture - 215,213 Future income tax provision (recovery) 2,190,000 (9,372,500) ------------------------------ 3,807,352 1,196,834 Cost of investments purchased (26,584,338) (85,827,511) Proceeds from investments sold 24,049,707 11,971,122 Net change in non-cash balances related to operations Accrued interest receivable (1,070,412) (1,475,270) Prepaid expenses (77,779) (174,153) Accounts payable and accrued liabilities 116,628 498,831 ------------------------------ 241,158 (73,810,147) ------------------------------ Cash flows from financing activities Dividends paid to common shareholders (note 5) (3,685,935) (614,322) Issuance of common shares on initial public offering, net of offering costs (note 4) - 94,161,178 ------------------------------ (3,685,935) 93,546,856 ------------------------------ Net (decrease) increase in cash during the period (3,444,777) 19,736,709 Cash and short-term deposits - beginning of period 6,042,756 - ------------------------------ Cash and short-term deposits - end of period 2,597,979 19,736,709 ------------------------------ ------------------------------ Cash and short-term deposits comprise Cash 2,597,979 2,642,930 Short-term deposits - 17,093,779 ------------------------------ 2,597,979 19,736,709 ------------------------------ ------------------------------ Supplemental cash flow information (note 10) The accompanying notes are an integral part of these financial statements. Deans Knight Income Corporation Statement of Investments As at June 30, 2010 (Unaudited) ---------------------------------------------------------------------------- Percentage of total fair Par value(1) Average cost(2) Fair value(2) value(3) $ $ $ % Fixed Income - Canadian Denominated in Canadian dollars Garda World Security 9.75% 03-15-2017 2,500,000 2,472,105 2,525,000 2.1 North American Energy Partners Inc. 9.125% 04-07-2017 8,000,000 8,000,000 8,000,000 6.5 Sherritt International Corp. 7.75% 10-15-2015 3,500,000 2,718,438 3,648,750 3.0 Sherritt International Corp. 7.88% 11-26-2012 1,200,000 903,000 1,245,000 1.0 --------------------------------------------- 14,093,543 15,418,750 12.6 --------------------------------------------- Denominated in United States dollars Bombardier Inc. 8.00% 11-15-2014 5,268,000 5,029,913 5,796,762 4.7 CCS Inc. 11.0% 11-15-2015 7,750,000 3,879,423 6,986,702 5.7 Dollarama Group Holdings FRN 08-15-2012 5,248,000 5,354,661 5,556,049 4.5 Gibson Energy ULC 11.75% 05-27-2014 2,000,000 2,220,493 2,296,199 1.9 Harvest Operations Corp.7.88% 10-15-2011(4) 5,500,000 4,708,549 5,847,883 4.8 Methanex Corporation 6.0% 08-15-2015 1,000,000 879,586 1,012,873 0.8 Methanex Corporation 8.75% 08-15-2012 3,750,000 4,098,591 4,126,397 3.4 Opti Canada Inc. 7.88% 12-15-2014 2,000,000 1,257,971 1,834,838 1.5 Pacific Rubiales Energy Corporation 8.75% 11-10-2016 2,500,000 2,655,612 2,837,105 2.3 Paramount Resources Ltd. 8.5% 01-31-2013 8,300,000 8,821,516 8,802,980 7.2 Teck Resources Limited 10.75% 05-15-2019 5,500,000 6,297,137 7,087,459 5.8 West Fraser Timber Co. Ltd. 5.2% 10-15-2014 1,250,000 974,216 1,246,205 1.0 --------------------------------------------- 46,177,668 53,431,452 43.6 --------------------------------------------- Total Canadian fixed income 60,271,211 68,850,202 56.2 --------------------------------------------- Fixed income - United States Denominated in United States dollars Beazer Homes USA, Inc. 9.13% 06-15-2018 3,250,000 3,327,056 3,205,664 2.6 Calfrac Holdings LP 7.75% 02-15-2015(4) 7,140,000 6,670,487 7,307,640 6.0 Calfrac Holdings LP 7.75% 02-15-2015 144A(4) 500,000 500,141 511,740 0.4 Cott Beverages Inc. 8.38% 11-15-2017 4,350,000 4,622,109 4,636,678 3.8 McMoRan Exploration Co. 11.88% 11-15-2014 2,000,000 2,114,471 2,163,624 1.8 MetroPCS Wireless Inc. 9.25% 11-01-2014 5,400,000 5,761,266 5,884,739 4.8 MetroPCS Wireless Inc. 9.25% 11-01-2014 1,500,000 1,594,520 1,638,627 1.3 --------------------------------------------- Total United States fixed income 24,590,050 25,348,712 20.7 Deans Knight Income Corporation Statement of Investments ...continued As at June 30, 2010 (Unaudited) ---------------------------------------------------------------------------- Percentage of total fair Par value(1) Average cost(2) Fair value(2) value(3) $ $ $ % Foreign Denominated in United States dollars FMG Finance Pty Ltd. 10.62% 09-01-2016 1,750,000 1,834,705 2,060,216 1.7 Denominated Australian dollars Western Areas NL 8.0% 07-02-2012 3,250,000 2,864,931 2,805,816 2.3 --------------------------------------------- Total foreign fixed income 29,289,686 30,214,744 24.7 --------------------------------------------- Total fixed income 89,560,897 99,064,946 80.9 --------------------------------------------- Convertible debentures Denominated in Canadian dollars Harvest Energy Trust 7.25% 09-30 -2013(4) 5,500,000 3,635,076 5,541,250 4.5 Trinidad Drilling Ltd. 7.75% 07-31-2012 6,441,000 5,365,364 6,505,410 5.3 Whitecap Resources Inc. 8.0% 09-30 -2012 7,500,000 7,500,000 12,930,750 10.5 --------------------------------------------- 16,500,440 24,977,410 20.3 --------------------------------------------- Investments subtotal 106,061,337 124,042,356 101.2 Hedges Denominated in United States and Australian dollars Foreign currency exchange contracts (note 9) 82,200,000 - (1,438,353) -1.2 --------------------------------------------- 106,061,337 122,604,003 100.0 --------------------------------------------- --------------------------------------------- (1) Par values are presented in their source currency (2) All amounts are shown in Canadian dollars (3) Percentages are shown as a percentage of total investments (4) These investments share a common director with the Company Deans Knight Income CorporationNotes to Financial StatementsJune 30, 2010(Unaudited)1 Nature of operations and basis of presentationDeans Knight Income Corporation (the "Company") is a corporation continued under the laws of Canada on April 11, 2001. The Company is a closed-end, non-redeemable investment company. It invests primarily, in corporate debt rated BBB or below by recognized credit rating organizations.Prior to the Company completing its reorganization in May 2008, it was in the business of pharmaceutical research. In May 2008, the Company was reorganized and the pharmaceutical research operations and all assets and liabilities were transferred out of the Company (note 2). In March 2009, the Company completed an initial public offering, whereby it raised gross proceeds of $100,368,900 (note 4) and began operating its new business of investing in corporate debt.The common shares of the Company will be redeemed on, or around, April 30, 2014, for a cash amount equal to 100% of the net asset value per share.The accompanying financial statements are prepared in accordance with Canadian generally accepted accounting principles ("GAAP"). All amounts are presented in Canadian dollars, unless otherwise noted.2 ReorganizationIn 2008, the Company reorganized its corporate structure and business, and issued a convertible debenture for $2,960,000. The convertible debenture was convertible into 20,683,685 voting common shares and 123,818,901 non-voting common shares at the option of the third party. On March 17, 2009, the third party opted to convert the full amount of the convertible debenture and interest accrued thereon (note 4).Prior to the Reorganization, the Company was a life sciences company involved in the research, development and commercialization of innovative products for the prevention and treatment of life-threatening diseases. Forbes Medi-Tech Inc ("Forbes"), who now carries on the prior business of the Company, has provided an indemnity to the Company with respect to liabilities relating to the Company's assets transferred to Forbes and the Company's prior business. In addition, Forbes obtained, on behalf of the Company, product liability insurance for certain claims that may arise in the future in connection with the Company's prior business. To date, no such claims or potential claims have arisen. There can be no assurance that the above noted guarantee will be sufficient to cover any future claims.3 Summary of significant accounting policiesThe following is a summary of significant accounting policies followed by the Company, and these policies are consistent with the most recent annual financial statements.Financial InstrumentsInvestmentsInvestments are held for trading and are recorded at fair values determined as follows:Short-term depositsShort-term deposits are valued at cost plus accrued interest, which approximates market value.Fixed income investmentsFixed income investments traded on a public securities exchange or traded on an over-the-counter market are valued at the closing bid price. Where no closing bid price is available, the last sale or close price is used, where, in management's opinion, this provides the best estimate of fair value. .Unlisted or non-exchange traded investments, or investments where a last bid, sale or close price is unavailable or investments for which market quotations are, in the Company's opinion, inaccurate, unreliable, or not reflective of all available material information, are valued at their fair value as determined by the Company using appropriate and accepted industry valuation techniques including valuation models. The fair value determined using valuation models requires the use of inputs and assumptions based on observable market data including volatility and other applicable rates or prices. In limited circumstances, the fair value may be determined using valuation techniques that are not supported by observable market data.The resulting values for investments not traded in an active market may differ from values that would be determined had a ready market existed, and the difference could be significant.Forward currency contractsForward currency contracts are recorded at fair value. The proceeds (payments) on contracts settled during the period are included in the net realized gain on investments sold (note 7). The Company's policy is to hedge 95% - 106% of the fair value of foreign denominated investments with foreign exchange forward sell contracts.The impact of changes in fair value on net income of the Company arising from changes in estimated fair value for investments is detailed in the statement of operations.Accrued interest receivableAccrued interest is designated as loans and receivables and is accounted for at amortized cost. Due to the immediate and short-term nature, carrying value approximates fair value.Financial liabilitiesFinancial liabilities, consisting of accounts payable and accrued liabilities, are designated as other financial liabilities and are accounted for at amortized cost. Due to the immediate and short-term nature, carrying value approximates fair value.Investment transactionsInvestment transactions are recorded on the trade date. Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of an investment, which include fees and commissions paid to agents, advisors, brokers and dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and duties. These costs are expensed and are included in the statement of operations.Cash and short-term depositsCash and short-term deposits consists of cash and deposits with maturities at the time of purchase of three months or less and are held with a Canadian chartered bank.Income recognitionIncome from investments is recognized on an accrual basis. Interest income is accrued based on the number of days the investment is held during the year. Gains or losses on the sale of investments, including foreign exchange gain or loss on such investments, are calculated on an average cost basis.Forward foreign currency contractsForward foreign currency contracts (note 9) entered into by the Company are valued at an amount that is equal to the gain or loss that would be realized if the position were to be closed out, which is equivalent to the difference between the deliverable asset and the value of the asset to be received. Changes in the value of a forward contract or the assets deliverable under such a contract are included as unrealized appreciation/depreciation of foreign currency contracts in the statement of operations.Foreign exchangeAssets and liabilities denominated in foreign currencies are translated into Canadian dollars at the exchange rate applicable on the valuation date. Purchases and sales of investments, investment income and expenses are calculated at the exchange rates prevailing on the dates of the transactions.Accretion in carrying value of convertible debentureThe carrying value of the liability component of the redeemable convertible debenture is accreted to the estimated redemption value using the effective yield method through charges to income over the year up to the redemption date.Income taxesThe Company follows the asset and liability method of accounting for income taxes. Future income tax assets and liabilities are measured using rates expected to apply to the taxable income in the years in which the temporary differences are expected to be settled. The Company accounts for uncertain tax positions using the contingent liability model, whereby a provision is established only where the probability that a payment will be required to be made is considered to be greater than 75%.A valuation allowance is recognized to the extent it is more likely than not that future income tax assets will not be realized. Management has estimated the income tax provision and future income tax balances taking into account its expectation of future income and an interpretation of the various income tax laws and regulations. It is possible, due to the complexity inherent in estimating income taxes, that the tax provision and future tax balances could change (note 8), and the change could be significant.Use of estimatesThe preparation of financial statements in conformity with Canadian generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, income and expenses. Actual results could differ from those reported and such differences could be material. Significant areas involving the use of estimates include determining the estimated fair value of private investments and future income tax assets.Net assets per common shareThe net assets per common share is computed by dividing the net assets of the Company by the total number of common shares outstanding on the valuation date.Increase in net assets from operations per weighted average common shareThe increase in net assets from operations per common share represents the increase in net assets from operations divided by the weighted average number of common shares outstanding during the period.The weighted-average number of shares outstanding during the period ended June 30, 2010 was 10,537,263 (June 30, 2009 - 6,097,337). This weighted average includes both the voting common shares and non-voting common shares of the Company.Comparative figuresCertain of the comparative figures have been re-classified to conform with the current period presentation.4 Capital stockThe Company is authorized to issue an unlimited number of voting common shares without par value, and an unlimited number of non-voting common shares without par value. Voting common shares Non-voting common shares ---------------------------------------------------- Number of Number of shares Amount shares Amount $ $ $ $ Balance - December 31, 2008 38,412,100 1 - - Shares issued on conversion of debenture 20,683,685 480,742 123,818,901 2,877,873 Shares issued for payment of interest owed on convertible debenture - - 8,227,260 215,213 Share consolidation (58,941,083) - (131,700,490) - ---------------------------------------------------- 154,702 480,743 345,671 3,093,086 Shares issued in initial public offering 10,036,890 100,368,900 - - Less: Offering costs - net of tax - (4,576,300) - - ---------------------------------------------------- Balance - December 31, 2009 and June 30, 2010 10,191,592 96,273,343 345,671 3,093,086 ---------------------------------------------------- ---------------------------------------------------- Total common shares outstanding at December 31, 2009 and June 30, 2010 10,537,263 99,366,429 -------------------------- -------------------------- On February 6, 2009, the Company cancelled its stock option plan and cancelled the authorized, but unissued, preferred shares.Initial Public OfferingOn March 17, 2009, the Company completed an initial public offering.Immediately prior to the initial public offering, the $2,960,000 convertible debenture was converted at the holder's option, resulting in the issuance of 20,683,685 voting common shares and 123,818,901 non-voting common shares. The value ascribed to these shares was the value of the convertible debenture, being $2,960,000, and the value of the equity component of the convertible debenture, being $398,615. The Company also issued 8,227,260 non-voting common shares in satisfaction of the $215,213 of interest owed on the convertible debenture.Immediately after the issuance of shares related to the Convertible Debenture and the related interest owed, the 59,095,785 voting common shares and the 132,046,161 non-voting common shares outstanding were consolidated on a 382 to 1 basis, into 154,702 voting common shares and the 345,671 non-voting common shares.The Company then issued 10,036,890 voting common shares at a price of $10.00 per share, for gross proceeds of $100,368,900. The net cash proceeds of $94,100,100 (June 30, 2009 - $94,161,178) were used to invest in a portfolio of debt instruments. As a result of the income tax benefit of $1,692,500 related to offering costs of $6,268,800, the total increase in share capital relating to voting common shares was $95,792,600 (June 30, 2009 - $95,853,678). Contributed surplus The contributed surplus balance did not change during the period, and consists of: June 30, December 31, 2010 2009 $ $ Surplus related to stock compensation, warrants and options associated with common shares 8,030,295 8,030,295 Surplus relating to warrants associated with previously issued preferred shares 1,874,209 1,874,209 ---------------------------- 9,904,504 9,904,504 ---------------------------- ---------------------------- 5 Retained earnings The changes in retained earnings for the period were as follows: $ Deficit - December 31, 2008 (13,159,390) Increase in net assets from operations 36,870,408 Dividends paid from net investment income (4,300,257) ------------- Retained earnings - December 31, 2009 19,410,761 Increase in net assets from operations 8,441,683 Dividends paid from net investment income (3,685,935) ------------- Retained earnings - June 30, 2010 24,166,509 ------------- ------------- 6 Related party transactions and balancesManagement fees are paid quarterly to Deans Knight Capital Management Ltd. (the Investment Advisor), a corporation with certain common directors and officers of the Company, for services received in connection with the management of the investment portfolio and financial accounts, among other services provided. Management fees are computed quarterly at an annual rate of 1.5% of Net Asset Value, adjusted for certain non-investment related assets. For the period ended June 30, 2010, management fees totalled $980,755 (June 30, 2009 - $424,864). Of this amount, $504,095 (December 31, 2009 - $476,700) was included in accounts payable and accrued liabilities in the statement of net assets at June 30, 2010, and is payable immediately.A director of the Company is a partner at a law firm that provides legal services to the Company. During the period ended June 30, 2010, the Company incurred $17,409 (June 30, 2009 - $330,000) in legal services and disbursements received from this related party. At June 30, 2010, accounts payable and accrued liabilities include $ nil (December 31, 2009 - $550) to the law firm for legal fees and disbursements.7 Net realized gains on investments sold and foreign currency contractsThe net realized gain (loss) on sale of investments for the period ended June 30 was as follows: 2010 2009 $ $ Proceeds from sale of investments 24,049,707 11,971,122 ---------------------------- Investments at cost - Beginning of period 100,510,397 - Add: Cost of investments purchased 26,584,338 85,827,511 ---------------------------- 127,094,735 85,827,511 Less: Investments at cost - End of period (106,061,337) (78,746,455) ---------------------------- Cost of investments sold 21,033,398 7,081,056 ---------------------------- Net realized gains on investments sold 3,016,309 4,890,066 ---------------------------- ---------------------------- Net realized gains on investments sold consists of: 2010 2009 $ $ Realized gains on securities sold 2,572,267 953,429 Realized gains on settlement of foreign currency contracts 444,042 3,936,637 ---------------------------- 3,016,309 4,890,066 ---------------------------- ---------------------------- 8 TaxationUncertainty of deductibility of tax lossesPrior to the reorganization and change in business as discussed in notes 1and 2, the Company had generated significant tax losses and other tax attributes as a result of its prior businesses and research activities. The Company has recorded, as a tax asset, the full amount of the potential tax benefit of such items to the extent of its projected taxable income. There is no guarantee that the tax authorities will allow the Company to deduct some, or all, of the tax losses and other attributes. Should the Company be denied the deductions, the recognized amount of the tax assets, as well as such amounts claimed to date, would be recorded as a charge to income. The total tax assets recognized and tax losses and other attributes claimed to date, which are subject to uncertainty, amount to $17,290,000 (December 31, 2009 - $15,647,415), representing $1.64 per common share at June 30, 2010 (December 31, 2009 - $1.48 per common share).Future tax assetCanadian GAAP requires a valuation allowance to be recognized against any future tax asset to the extent that it is more likely than not that the future income tax asset will not be realized. This is also the Company's stated accounting policy.Prior to commencing operations as an investment corporation in March 2009, the Company had determined that it had not met this test. As such, the Company recorded a full valuation allowance against the potential value of all of its tax losses and deductions available to be taken against future years' taxable income.As the Company's investments in debt securities are now generating interest income, and are expected to continue to generate income during the years of operations through to April 30, 2014, the Company concluded that the valuation allowance should be reduced accordingly. The difference between the total value of these tax benefits less the valuation allowance, being $6,010,000 (December 31, 2009 - $8,200,000), is the amount of the future income tax asset that has been recorded by the Company in the statement of net assets. The valuation allowance is reviewed periodically, based on updated projections of taxable income, and adjusted accordingly by a credit or charge to the statement of operations in that period.The tax effects of temporary differences that give rise to significant components of the future income tax assets at the statutory enacted rates are as follows: June 30, December 31, 2010 2009 $ $ Future tax assets Non-capital loss carry-forwards 3,718,750 5,150,041 Research and development expenditures 8,599,750 8,599,750 Investment tax credits 5,677,600 5,677,600 Share issuance costs 977,900 1,316,448 Property, plant and equipment and intangible assets - 490,500 ---------------------------- Total gross future tax assets 18,974,000 21,234,339 Valuation allowance (12,964,000) (13,034,339) ---------------------------- Net future tax asset 6,010,000 8,200,000 Less: current portion (2,358,000) (2,210,000) ---------------------------- 3,652,000 5,990,000 ---------------------------- ---------------------------- The tax balances and income tax expense recognized by the Company are based on management's interpretation of the tax laws. Due to the complexity inherent in tax interpretations, regulations and legislation, there are significant estimates required to compute income tax balances. It is possible that some or all of the Company's significant components of the future income tax assets may not be deductible for tax purposes and, accordingly, the amount of future income taxes and provision for (recovery of) income taxes recorded in the financial statements could change by a material amount.In determining the amount of future income tax assets recognized management assessed the projected taxable income of the Company. Inherent in all forward looking information is uncertainty and actual amounts could differ from these estimates and the difference could be material. In developing the projection, management has assumed full payment of all contractual interest, that investments maturing prior to April 30, 2014 will be redeemed for par value and reinvested funds will achieve an 8% yield.Tax pools available to offset future tax expense and payableThe operations of the Company and related tax interpretations, regulations and legislation are continually changing. As a result, there are significant estimates required to compute income tax balances. As at June 30, 2010, the Company has accumulated scientific research and experimental development expenditures in the amount of $34,399,000 available for carry-forward indefinitely. The Company also has accumulated approximately $7,097,000 of unclaimed federal investment tax credits and accumulated non-capital losses in the amount of $14,303,000. The investment tax credits and non-capital losses for income tax purposes expire as follows: Investment Non-capital tax credits losses $ $ Year of expiry 2018 265,000 2019 990,000 2020 1,872,000 2021 2,483,000 2022 298,000 2023 187,000 2024 496,000 2025 506,000 2026 2,002,000 2027 9,823,000 2028 2,478,000 ---------------------------- 7,097,000 14,303,000 ---------------------------- ---------------------------- Reconciliation of income tax expense The reconciliation of income tax computed at the statutory tax rate to income tax expense, using a 28.5% statutory tax rate (2009 - 30%) is: June 30, June 30, 2010 2009 $ $ Income before income taxes 10,631,683 14,240,746 Statutory tax rate 28.5% 30% ---------------------------- Income tax expense at statutory rates 3,030,030 4,272,224 Use of prior year losses (2,672,708) (3,927,215) Changes in valuation allowance 2,190,000 (11,065,000) Income tax benefit related to offering cost - 1,692,500 Share issuance costs (357,322) (345,009) ---------------------------- Income tax provision (recovery) 2,190,000 (9,372,500) ---------------------------- ---------------------------- 9 Financial instruments The following tables illustrate the classification of the Company's financial instruments within the fair value hierarchy: Financial assets at fair value - June 30, 2010 ---------------------------------------------------- Level 1 Level 2 Level 3 Total $ $ $ $ Bonds - 88,026,223 8,232,908 96,259,131 Convertible debentures - 12,046,660 15,736,565 27,783,225 Foreign currency forward contract - (1,438,353) - (1,438,353) ---------------------------------------------------- - 98,634,530 23,969,473 122,604,003 ---------------------------------------------------- ---------------------------------------------------- Financial assets at fair value - December 31, 2009 ---------------------------------------------------- Level 1 Level 2 Level 3 Total $ $ $ $ Bonds - 75,338,513 11,616,418 86,954,931 Convertible debentures - 15,636,660 10,561,008 26,197,668 Foreign currency forward contract - 92,441 - 92,441 ---------------------------------------------------- - 91,067,614 22,177,426 113,245,040 ---------------------------------------------------- ---------------------------------------------------- All investments remained at their respective levels within the fair value hierarchy during the periods. The following table reconciles the Company's Level 3 fair value measurements: Fair value measurements of Level 3 inputs -------------------------------------------- Convertible Bonds debentures Total $ $ $ Balance - December 31, 2008 - - - Purchases 9,671,316 10,364,931 20,036,247 Unrealized appreciation included in net gain on investments 1,945,102 196,077 2,141,179 -------------------------------------------- Balance - December 31, 2009 11,616,418 10,561,008 22,177,426 Sales (4,750,001) - (4,750,001) Unrealized appreciation included in net gain on investments 1,366,491 5,175,557 6,542,048 -------------------------------------------- Balance - June 30, 2010 8,232,908 15,736,565 23,969,473 -------------------------------------------- -------------------------------------------- Level 3 fair value measurements have predominantly been valued by considering data inputs such as the last price the security was traded at, most recent bid/ask information, prices of similar securities with available prices, and comparison of yields of comparable investments.Management of financial risksIn the normal course of business, the Company is exposed to various financial risks, including credit risk, liquidity risk and market risk (consisting of interest rate risk, currency risk and other price risk). The Company's overall risk management program seeks to minimize potentially adverse effects of these risks on the Company's financial performance by employing a professional, experienced portfolio adviser, monitoring daily the Company's positions and market events, diversifying the investment portfolio within the constraints of the investment guidelines and periodically using derivatives to hedge certain risk exposures. Further, the Company monitors the portfolio to ensure compliance with its investment strategy, investment guidelines and securities regulations.Fair value riskThe Company's investments are exposed to market price risk and this risk affects the fair value of the investments. All investments in fixed income investments have an inherent risk of loss of capital. The maximum risk resulting from investments is determined by their fair value. The Company seeks to manage valuation risks by careful selection of fixed income investments prior to making an investment and by regular ongoing monitoring of the investment performance of the individual investee companies.Credit riskCredit risk is the risk that a counterparty to a financial instrument will fail to discharge an obligation or commitment that it has entered into with the Company.All transactions executed by the Company in listed securities are settled/paid for upon delivery using approved brokers. The risk of this settlement not occurring is considered minimal, as delivery of securities sold is only made once the broker has received payment. Payment is made on a purchase once the securities have been received by the broker. The trade will fail if either party fails to meet its obligation. Since the Company invests in high-yield debt instruments and derivatives, this represents the main concentration of credit risk. The fair value of debt securities includes consideration of the creditworthiness of the debt issuer. The maximum credit exposure of these assets is represented by their carrying amounts. This maximum exposure may be offset to varying degrees in each investment, based on the collateral held, if any. Collateral may include such things as a general security agreement over all assets, or specific security over specific assets. It may also entitle the debt holder to take over the overall business, through restructuring of the investment. The Company's credit risk exposure by credit ratings on its investments is listed as follows: As a % of net assets ------------------------ June 30, December 31, 2010 2009 Credit rating BBB 5.3 - BB 17.2 18.3 B 39.1 25.1 CCC 10.6 10.3 Not rated(i) 20.8 34.2 ------------------------ 93.0 87.9 ------------------------ ------------------------ (i) Unrated debt securities consist primarily of convertible debentures and promissory notes in publicly traded companies Credit ratings are obtained from Standard & Poor's and/or Moody's. Where one or more rating is obtained for a security, the lowest rating has been used. The Company's credit risk exposure by sector on its investments is as follows: As a % of net assets ------------------------ June 30, December 31, 2010 2009 Sector Energy 53.8 56.2 Materials and metals 12.6 16.9 Consumer goods 9.5 2.8 Industrial/manufacturing 6.7 4.5 Telecommunications 5.6 4.4 Chemicals 3.9 - Forestry 0.9 0.8 Precious metals - 2.3 ------------------------ 93.0 87.9 ------------------------ Interest rate riskInterest rate risk arises from the possibility that changes in interest rates will affect future cash flows or fair values of financial instruments.The Company invests in interest-bearing financial instruments. As such, the Company is exposed to the risk that the value of such financial instruments will fluctuate due to changes in the prevailing levels of market interest rates. The table below summarizes the Company's exposure to interest rate risk by term to maturity: At Fair Value ---------------------------- June 30, December 31, 2010 2009 $ $ Maturity Less than 1 year (1,438,353) 1,942,441 1 - 3 years 47,820,285 42,986,354 3. 5 years 34,221,624 35,149,061 Greater than 5 years 42,000,447 33,167,184 ---------------------------- 122,604,003 113,245,040 ---------------------------- As at June 30, 2010, if the prevailing interest rates had been raised or lowered by 1%, assuming a parallel shift in the yield curve, with all other factors remaining constant, net assets could possibly have decreased or increased, respectively by approximately $4,118,868, or approximately 3.1% of net assets (December 31, 2009 - $3,590,949, or approximately 2.8% of net assets).Liquidity riskAs the Company is a publicly traded, closed-end investment company with a fixed number of common shares outstanding, unlike an open-ended mutual fund, it is not exposed to the liquidity risk associated with daily cash redemptions of securities.Investments in fixed income investments may not be able to be liquidated quickly at an amount close to their fair value to respond to specific events such as deterioration in the creditworthiness of any particular issuer. Fixed income investments purchased by the Company may be subject to resale restrictions such as hold periods. The resulting values for fixed income investments may differ from values that would be realized had a ready market existed.The Company actively reviews its investment portfolio, and the fixed income market, to assess liquidity risk on its holdings.Currency riskCurrency risk is the risk that the value of a financial instrument will fluctuate due to changes in foreign exchange rates. The Company invests a portion of its assets is securities that are denominated in a currency other than the Canadian dollar, which represents the functional currency of the Company. Consequently, the Company is exposed to currency risk as the value of the portfolio securities denominated in currencies other than the Canadian dollar will vary due to changes in foreign currency exchange rates.The Company enters into foreign currency contracts with financial institutions to hedge the value of foreign currency denominated investments. The fair value of these contracts is reflected in investments. Gains or losses arising from these contracts offset the gains or losses from the underlying investments. The unrealized gains or losses are reflected in unrealized appreciation/depreciation on foreign currency contracts on the statement of operations.The tables below indicate the foreign currency to which the Company had significant exposure in Canadian dollar terms. The tables also illustrate the potential impact to the Company's net assets, all other variables held constant, as a result of a 5% change in this currency relative to the Canadian dollar, assuming the forward currency contracts in place did not offset the foreign currency risk. As at June 30, 2010 ------------------------- Cash and Foreign term exchange Impact on Investments deposits contracts Total net assets $ $ $ $ $ Currency United States dollars 80,840,380 959,180 (1,325,743) 80,473,817 4,023,691 As a % of net assets 60.6 0.7 -1.0 60.3 3.0 Australian dollars 2,805,816 - (112,610) 2,693,206 134,660 As a % of net assets 2.1 0.0 -0.1 2.0 0.1 As at December 31, 2009 ------------------------- Cash and Foreign term exchange Impact on Investments deposits contracts Total net assets $ $ $ $ $ Currency United States dollars 71,989,931 1,259,819 18,727 73,268,477 3,663,424 As a % of net assets 55.9 1.0 0.0 56.9 2.8 Australian dollars 3,061,008 - 73,714 3,134,722 156,736 As a % of net assets 2.4 - 0.1 2.5 0.1 At June 30, 2010, the Company had outstanding foreign exchange contracts to sell US$79,000,000 and AUS$3,200,000 against future commitments at exchange rates ranging between 1.03418 and 1.05815 for US dollar foreign exchange contracts and 0.86 for the AUS foreign exchange contract. Those contracts have maturities ranging up to July 29, 2010. 10 Supplemental cash flow information Six-month period ended June 30, -------------------------------- 2010 2009 $ $ Non-cash financing transactions Non-voting common shares issued on conversion of debenture (note 4) - 2,877,873 Voting common shares issued on conversion of debenture (note 4) - 480,742 Non-voting common shares issued for payment of interest on debenture (note 4) - 215,213 Future income tax benefit from offering costs (note 4) - 1,692,500 11 Capital managementThe capital of the Company is divided in voting and non-voting common shares, each having an unlimited authorized amount. The number of voting and non-voting shares outstanding, and changes thereto, are outlined in note 4.The Company manages its capital in accordance with the Company's investment objectives. The Company's investment objectives are to: (i) maximize the total return for common shareholders, consisting of dividend income and capital appreciation; and (ii) provide shareholders with monthly dividends targeted to payout a minimum of 75% of net earnings annually. Net earnings in reference to the Company's dividend payments to shareholders excludes any realized and unrealized capital gains and losses from debt securities in the portfolio and any income or loss not derived from debt securities in the portfolio. The Company commenced its dividend payments on June 30, 2009, making monthly payments of $0.0583 per voting and non-voting common share, or $614,322. During the six-month period ended June 30, 2010, the Company made dividend payments of $3,685,935 (June 30, 2009 - $614,322).The Company is committed to pay a monthly dividend of $0.0583 per voting and non-voting common share for the three months ending September 30, 2010, totalling $1,842,966.12 Comparison of net asset value per share and net assets per shareIn accordance with Section 3.6(1) of National Instrument 81-106, the Company's net asset value per share, the net assets per share calculated in accordance with Canadian GAAP for financial reporting purposes, and an explanation of the differences between such amounts, are required disclosures in the notes to the financial statements. For investments that are traded in an active market, Canadian GAAP requires that bid prices be used in the fair value of instruments, rather than the use of the last traded price, as currently used for the purpose of determining net asset value. This change accounts for the difference between the net asset value and the net assets. $ Net asset value per share 12.71 Canadian GAAP adjustments (0.05) Net assets per share 12.66 13 Subsequent eventsOn July 7, 2010, the Company announced a monthly dividend of $614,322, or $0.0583 per common share, payable on each of July 30, 2010, August 31, 2010 and September 30, 2010.FOR FURTHER INFORMATION PLEASE CONTACT: Deans Knight Income Corporation Craig Langdon Chief Executive Officer and Director (604) 669-0212 or Deans Knight Income Corporation Mark Myles Chief Financial Officer (604) 669-0212