The Globe and Mail

Go to the Globe and Mail homepage

Jump to main navigationJump to main content

Globe Investor

News Sources

Take control of your investments with the latest investing news and analysis

Press release from Marketwire

Deans Knight Income Corporation Releases Annual Management Report of Fund Performance and Financial Statements for the Year Ended December 31, 2010

Friday, March 18, 2011

Deans Knight Income Corporation Releases Annual Management Report of Fund Performance and Financial Statements for the Year Ended December 31, 201003:21 EDT Friday, March 18, 2011VANCOUVER, BRITISH COLUMBIA--(Marketwire - March 18, 2011) - Deans Knight Income Corporation (the "Company") (TSX:DNC) is pleased to release its annual Management Report of Fund Performance and Financial Statements for the year ended December 31, 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.This annual 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 annual financial statements of the Company for the year ended December 31, 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. Readers 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. In particular, this Report contains forward-looking statements in respect of 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. 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. Such forward-looking statements reflect the Company's current beliefs and are based on information currently available to the Company. 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, currency, exchange and interest rates. 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 global equity and capital markets, business competition, technological change, changes in government regulations, unexpected judicial or regulatory proceedings, and catastrophic events and the risks outlined under "Risk Factors" in the AIF (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 (as defined herein), consisting of dividend income and capital appreciation; and (ii) provide Shareholders with monthly dividends, which to date have been set at $0.0583 per share 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. Examples of investments made during the period are detailed below in the Results from Operations.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 securities to purchase for the Company, Deans Knight focuses on the following:- amount of security or collateral within a business to support the value of the securities;- 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 intends to employ 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 annual information form of the Company dated March 15, 2011 (the "AIF").Prior to the reorganization and change in business as discussed in Note 1 of the Financial Statements, the Company 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 uncertainty as to whether 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 in full, 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 $20,747,249 (2009 - $15,647,415), representing $1.97 per common share at December 31, 2010 (2009 - $1.48).There were no significant changes during the year ending December 31, 2010 that affected the overall risk of investing in the Company. 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 are willing to tolerate volatility in the value of their investment.Results of OperationsThe net assets of the Company at December 31, 2010 were $143,343,361 or $13.60 per common share (2009 - $128,681,694 or $12.21 per common share). The net assets of the Company consisted of the following components: December 31, 2010 --------------------------------- Per common $ share(1) %Investments(2) 128,449,450 12.19 89.6Cash and short-term deposits 7,137,967 0.68 5.0Accrued income 1,808,756 0.17 1.2Prepaid expenses 89,662 0.01 0.1Future income tax asset(3) 6,550,000 0.62 4.6Accounts payable and accrued liabilities (692,474) (0.07) (0.5) --------------------------------- 143,343,361 13.60 100.0 --------------------------------- ---------------------------------(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.(3) Refer to the Taxation note to the Financial Statements for more detail. December 31, 2010 --------------------------------- Per common $ share(1) %Investments(2) 113,245,040 10.74 87.9Cash and short-term deposits 6,042,756 0.57 4.7Accrued income 1,670,248 0.16 1.3Prepaid expenses 89,840 0.01 0.1Future income tax asset(3) 8,200,000 0.78 6.4Accounts 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 included in the 2009 Management Report of Fund Performance(3) Refer to the Taxation note to the Financial Statements for more detail.During 2010, the Company made 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 2010 of $0.70 per share (2009 - $0.41 per share). On January 6, 2011, the Company announced it will maintain monthly cash dividends at $0.0583 per share for each of the first three months of 2011.Net investment income during the year ended December 31, 2010 was $7,376,571 (2009 - $4,500,960). The increase in net investment income of $2,875,611 was due predominantly to the Company earning income for the entire year of 2010, whereas in 2009 it only earned income once investments were made, starting in March 2009. Furthermore, the Company did not incur any expenses related to the convertible debenture repaid in March 2009.As the Company has previously stated, it believes higher yielding shorter term corporate bonds are a more attractive investment than government or high grade corporate bonds. Government and corporate investment grade yields are simply too low to compensate investors for the risk of rising interest rates. By contrast, the shorter maturity schedule and relative strength of the companies within the portfolio provide an attractive income stream where investors are being compensated for the risk.Even though the current spread in yields between U.S. 10-year treasuries and high yield bonds has narrowed to the long term average (see graph below) the Company is still uncovering attractive opportunities within the high yield universe. http://media3.marketwire.com/docs/credit_graph.jpg The Company is focused on investing in debt instruments of businesses with tangible assets as collateral, strong cash flows and reasonable leverage, with covenants which limit the issuance of additional debt that would rank ahead of the Company.For example, the Company participated in the new issue of Cara Operations Limited ("Cara") 9.125% Senior Secured Notes due December 1, 2015 ("Cara Notes"). Cara is an owner, operator and franchisor of full service and quick service restaurants across Canada. Cara's restaurant portfolio includes Swiss Chalet Rotisserie & Grill, Milestones Grill & Bar, Montana's Cookhouse, Kelsey's Neighbourhood Bar & Grill and Harvey's. Cara has a strong management team and currently has stable free cash flow. As management of Cara expands its brands further into western Canada, which appears will require modest capital expenditures by Cara, the Company believes that leverage will naturally improve the credit quality of the Cara Notes. Deans Knight believes at a yield of 9.125%, the Company is well compensated for the risk.The Company also attempts to add additional value, by opportunistically investing in private debt financings with equity incentives that provide additional capital appreciation. The Company participated in three private financings over the past 18 months. In August 2009, the Company purchased a portion of structured a $10 million, 8% convertible debenture ("Whitecap Debenture") for Whitecap Resources Inc. ("Whitecap"), a junior Calgary-based oil and gas producer. Deans Knight is very familiar with and has great confidence in the management team of Whitecap, and has invested successfully with the same management team in previous initiatives. Whitecap grew production from 850 barrels of oil equivalent per day ("boepd") to 2,900 boepd, 60% of which is oil. The Whitecap Debenture had an exercise price of $2.88 and on December 8, 2010, the Company converted the Whitecap Debenture into equity and subsequently sold a portion of its holding at $6.16 per share. The Company still holds shares of Whitecap (5.5% of the Company's net asset value), as the Company believes management can grow production per share and create additional value for shareholders going forward.In the past three months, Deans Knight, on behalf of its clients, provided a $20 million secured subordinated credit facility (the "Facility") to Sure Energy Inc. ("Sure"), another junior oil and gas producer, where again Deans Knight has invested in other companies previously managed by the principals of Sure. Sure is currently producing 1,250 boepd, 46% of which is oil & liquids. Sure is undergoing a transition to a higher growth oil producer, with a significant position in the emerging Viking light oil resource at Redwater in the Plains area of central Alberta, an extensive inventory of low risk oil development (45 locations) and additional oil inventory (74 locations). The required use of proceeds by Sure under the Facility is for the development of the Viking asset and for infrastructure to increase production.On December 21, 2010, Sure drew down $10 million of the Facility; of which the Company provided $2.5 million (1.7% of the Company's net asset value). Additional draws on the Facility may be made at Sure's discretion in minimum tranches of $2.5 million. The drawn portion of the Facility bears interest at 6.25 percent per annum. The undrawn portion bears a standby fee of 0.25 percent. The Facility matures on January 21, 2014. Further, 625,000 common share purchase warrants of Sure, at a price of $1.80 per share, were issued as additional consideration to the Company in connection with the Facility. These warrants expire on December 21, 2013. As of December 31, 2010, the common shares of Sure closed at $1.75 on the Toronto Stock Exchange.Finally, on November 15, 2010, the Company participated in a short term debenture ("P1 Debenture") with P1 Energy Corp. (3.5% of the Company's net asset value). The P1 Debentures bore interest at 12 percent per annum and paid a 2.5% set-up fee at maturity. Subsequent to year-end on January 12, 2011, the P1 Debenture was repaid providing a return of 4.4% in 58 days to the Company, which equates to an annualized return of 27.7%.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") and (ii) another for all other purposes, including unit pricing for investor transactions (referred to as "net asset value"). 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 December 31, 2010 (2009 - $0.02 per common share), 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, on January 12, 2011, the AcSB issued a decision to defer adoption of IFRS for investment companies until years beginning on or after January 1, 2013. This is a further delay from the previously issued 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 the above noted decision, the Company's first set of financial statements to be reported on under IFRS will be for the semi-annual period ending June 30, 2013. These statements will include corresponding comparative financial information for 2012, including an opening statement of net assets as at January 1, 2012.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, 2012 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 2011 and 2012. This potential for change creates some uncertainty regarding the expected accounting standards that will be applicable upon the Company adopting IFRS. As such, the Company cannot conclusively determine the impact that the adoption of IFRS will have.Throughout 2011 and 2012, 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 were subject to the 5% GST, but not PST, these services are subject to the new HST. Since the Company is not able to recover this tax, the 8% difference represents an additional cost to the Company.Related Party TransactionsThe officers, and certain directors, of the Company are also employees of Deans Knight, the Company's investment advisor. 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 year ended December 31, 2010, management fees totaled $2,110,657 (2009 -$1,361,226). At December 31, 2010, $599,474 (December 2009 - $476,700) was owed to Deans Knight, which was included in accounts payable and accrued liabilities in the statement of net assets, and is payable immediately. In calculating the management fee, 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 year ended December 31, 2010, the Corporation incurred $30,195 (2009 - $355,000) in legal services and disbursements received from this related party. At December 31, 2010, accounts payable and accrued liabilities include $1,355 (2009 - $550) to the law firm for legal fees and disbursements, which had 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) 2010 2009 $ $--------------------------------------------------------------------------------------------------------------------------------------------------------Net assets, beginning of period (2)(3) 12.21 9.12Increase (decrease) from operationsTotal revenue 0.94 0.62Total expenses (0.24) (0.20)Realized gains (losses) for the period 1.82 1.25Unrealized gains (losses) for the period (0.27) 1.21Recovery of future income taxes (0.16) 0.62----------------------------------------------------------------------------Total increase (decrease) from operations (3) 2.09 3.50--------------------------------------------------------------------------------------------------------------------------------------------------------Dividends (3)(4)From income (0.70) (0.41)----------------------------------------------------------------------------Net assets at end of period (5) 13.60 12.21--------------------------------------------------------------------------------------------------------------------------------------------------------(1) The information is derived from the Company's audited annual 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 2009 reflect the net assets in the Company at March 17, 2009, after giving effect to the conversion of the convertible debenture (as described in Note 2 to the Financial Statements) and interest owing thereon and the issuance of common shares on the Company's initial public offering 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. For 2009, the period is 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 (1) 2010 2009--------------------------------------------------------------------------------------------------------------------------------------------------------Net asset value (000's) $143,880 $128,930Number of common shares outstanding (000's) 10,537 10,537Management expense ratio (2) (3) 1.91% 5.51%Portfolio turnover rate (4) 86.60% 36.69%Trading expense ratio (5) 0.01% 0.01%Net asset value per common share $ 13.65 $ 12.23Closing market price - common share $ 12.54 $ 11.40(1) This information is provided as at December 31 of the years shown.(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 initial public offering of the Company 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 $13,500 for 2010 (2009 - $13,050), 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. Also note that the performance information does not take into account sales, redemptions, or other optional charges that would have reduced returns on performance. 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 years shown and illustrates how the Company's performance has changed from year to year. The bar chart shows, in percentage terms, how much an investment made from when the Company began its operation as an investment fund on March 17, 2009 to December 31, 2009, and how much an investment made for the year ending December 31, 2010. http://media3.marketwire.com/docs/dnc_graph2.jpg Annual Compound ReturnsThe table below summarizes the Company's annual compound total returns for the periods ended December 31 as indicated. As a basis for comparison, we have provided the performance of the Merrill Lynch Canada High Yield Bond Index ("Index"). The Index is a broad based index that tracks the performance of the Canadian high-yield bond market. As the criteria for determining the constituents of the Company and the Index differ, it is not expected that the Company's performance will mirror that of the Index. Further, the return of the Index is calculated without the deduction of management fees and fund expenses whereas the performance of the Company is calculated after deducting fees and expenses.----------------------------------------------------------------------------Period Company Index----------------------------------------------------------------------------1 Year 16.4 13.5----------------------------------------------------------------------------Since Inception 24.5 36.9----------------------------------------------------------------------------Summary of Investment PortfolioThe following is a summary of the Company's investment portfolio as at December 31, 2010. This is a summary only and will change due to ongoing portfolio transactions of the Company. A quarterly update is available at www.dkincomecorp.com.--------------------------------------------------------------------------------------------------------------------------------------------------------Top 25 investments % of Net Portfolio % of Net asset value composition asset valueParamount Resources 8.3% 12-13-2017 6.6 Equity 5.8North America Energy Partners Inc. 9.1% 04-07-2017 6.4Stone Energy Corp 8.6% 02-01-2017 6.2 Fixed IncomeWhitecap Resources Inc. Canadian - common shares 5.5 denominated in CAD 31.2CCS Inc. 11.0% 11-15-2011 4.9 Canadian denominated in USD 24.1Calfrac Holdings LP 7.5% 12-01-2020 4.2 United States denominated in USD 19.0 ------Harvest Energy 7.3% 09- 30-2013 3.9 74.3Trinidad Drilling 7.9% 01-15-2019 3.7 ------P1 Energy Corp. 12.0% 03-31-2011 3.5 Convertible DebenturesCott Beverages Inc. 8.4% 11-15-2017 3.3 Canadian denominated in CAD 6.5National Money Mart 10.4% Other Foreign 12-15-2016 3.0 denominated in AUD 2.5 ------Methanex Corp. 8.8% 08-15-2012 2.7 9.0Tembec Industries 11.3% 12-15-2018 2.7 ------Cara Operations Ltd. 9.1% 12-01-2015 2.7 Investment Portfolio 89.1Sherritt International Corp. 7.8% 10-15-2015 2.6 Cash and cash equivalents 4.9Trinidad Drilling 7.8% 07-31-2012 2.6 Other Net Assets 6.0NewAlta Corp. 7.6% 11-23-2017 2.3 ------Beazer Homes USA, Inc. 9.1% 100.0 06-15-2018 2.2 ------Pacific Rubiales Energy Corp. 8.8% 11-10-2016 1.9 Sector BreakdownGarda World Security 9.8% 03-15-2017 1.8 Energy 57.2Harvest Operations 6.9% 10-01-2017 1.8 Consumer goods 9.4Sure Energy Inc. 6.3% 01-21-2014 1.7 Materials and metals 6.0Gateway Casinos 8.9% 11-15-2017 1.6 Forestry 4.3Gibson Energy ULC 11.8% 05-27-2014 1.5 Services 3.6McMoran Exploration 11.9% 11-15-2014 1.5 Chemicals 3.4 Financial Services 3.0 Industrial/manufacturing 2.2 ------ Investment Portfolio 89.1 Cash and cash equivalents 4.9 Other net assets 6.0 ------ 100.0--------------------------------------------------------------------------------------------------------------------------------------------------------Deans Knight Income CorporationStatement of Net AssetsDecember 31, 2010--------------------------------------------------------------------------- 2010 2009 $ $AssetsCurrentInvestments - at fair value (cost - December 31, 2010 - $118,563,957; December 31, 2009 - $ 100,510,397) 128,449,450 113,245,040Cash and cash equivalents 7,137,967 6,042,756Accrued interest receivable 1,808,756 1,670,248Prepaid expenses 89,662 89,840Future income tax benefits (note 8) 2,150,000 2,210,000 ----------------------------------- 139,635,835 123,257,884Non-currentFuture income tax benefits (note 8) 4,400,000 5,990,000 ----------------------------------- 144,035,835 129,247,884 ----------------------------------- -----------------------------------LiabilitiesAccounts payable and accrued liabilities (note 6) 692,474 566,190 -----------------------------------Net assets 143,343,361 128,681,694 ----------------------------------- -----------------------------------Shareholders' equityCommon shares (note 4) 99,366,429 99,366,429Contributed surplus (note 4) 9,904,504 9,904,504Retained earnings (note 5) 34,072,428 19,410,761 ----------------------------------- 143,343,361 128,681,694 ----------------------------------- -----------------------------------Number of common shares outstanding (note 4) 10,537,263 10,537,263 ----------------------------------- -----------------------------------Net assets per common share (notes 8 and 12) 13.60 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 CorporationStatement of OperationsYear ended December 31--------------------------------------------------------------------------- 2010 2009 $ $Investment incomeInterest and other 9,928,769 6,563,633 ----------------------------------ExpensesManagement fees (note 6) 2,110,657 1,361,226Directors' fees and expenses 136,347 133,345Audit, accounting and tax fees 142,515 66,195Public company reporting costs 127,949 62,681Foreign exchange (gain) loss (56,760) 42,714Custodial fees 35,795 40,439Legal fees 30,195 15,080Transaction costs 13,500 10,050Independent Review Committee fees 12,000 12,000Accretion on convertible debenture (note 4) - 103,730Interest on convertible debenture (note 4) - 215,213 ---------------------------------- 2,552,198 2,062,673 ----------------------------------Net investment income 7,376,571 4,500,960 ----------------------------------Realized and unrealized gains (losses) on investmentsNet realized gain on investments sold (note 7) 15,928,417 5,590,551Net realized gain on settlement of foreign currency contracts (note 7) 3,227,698 7,536,754Change in unrealized (depreciation) appreciation on investments (3,674,974) 12,642,202Unrealized appreciation on foreign currency contracts 825,824 92,441 ----------------------------------Net gain on investments 16,306,965 25,861,948 ----------------------------------Increase in net assets from operations before tax 23,683,536 30,362,908(Provision for) recovery of future income tax (note 8) (1,650,000) 6,507,500 ----------------------------------Increase in net assets from operations 22,033,536 36,870,408 ---------------------------------- ----------------------------------Increase in net assets from operations per weighted average common share (note 3) 2.09 4.42 ---------------------------------- ----------------------------------The accompanying notes are an integral part of these financial statements.Deans Knight Income CorporationStatement of Changes in Net AssetsYear ended December 31--------------------------------------------------------------------------- 2010 2009 $ $Increase in net assets from operations 22,033,536 36,870,408 ----------------------------------Dividends to common shareholders (note 11) (7,371,869) (4,300,257) ----------------------------------Shareholder transactions (note 4)Issuance of common shares on conversion of debenture - 3,358,615Conversion of equity component of convertible debenture - (398,615)Issuance of common shares for payment of interest on convertible debenture - 215,213Issuance of common shares on initial public offering, net of offering costs - 95,792,600 ---------------------------------- - 98,967,813 ----------------------------------Increase in net assets during the year 14,661,667 131,537,964Net assets (liabilities) - Beginning of year 128,681,694 (2,856,270) ----------------------------------Net assets - End of year 143,343,361 128,681,694 ----------------------------------The accompanying notes are an integral part of these financial statements.Deans Knight Income CorporationStatement of Cash FlowsYear ended December 31--------------------------------------------------------------------------- 2010 2009 $ $Cash flows from operating activitiesIncrease in net assets from operations 22,033,536 36,870,408 Items not affecting cash Net realized gain on investments sold (15,928,417) (5,590,551) Net realized gain on settlement of foreign currency contracts (3,227,698) (7,536,754) Change in unrealized depreciation (appreciation) on investments 3,674,974 (12,642,202) Unrealized appreciation on foreign exchange contacts (825,824) (92,441) Accretion on convertible debenture - 103,730 Interest on convertible debenture - 215,213 Future income tax provision (recovery) 1,650,000 (6,507,500) ---------------------------------- 7,376,571 4,819,903Cost of investments purchased (note 7) (106,283,479) (125,360,814)Proceeds from investments sold (note 7) 107,386,034 37,977,722Net change in non-cash balances related to operations Accrued interest receivable (138,508) (1,670,248) Prepaid expenses 178 (89,840) Accounts payable and accrued liabilities 126,284 566,190 ---------------------------------- 8,467,080 (83,757,087) ----------------------------------Cash flows from financing activitiesDividends paid to common shareholders (note 5) (7,371,869) (4,300,257)Issuance of common shares on initial public offering, net of offering costs (note 4) - 94,100,100 ---------------------------------- (7,371,869) 89,799,843 ----------------------------------Net increase in cash during the year 1,095,211 6,042,756Cash and cash equivalents - Beginning of year 6,042,756 - ----------------------------------Cash and cash equivalents - End of year 7,137,967 6,042,756 ----------------------------------Cash and cash equivalents compriseCash 5,340,955 5,942,803Short-term deposits 1,797,012 99,953 ---------------------------------- 7,137,967 6,042,756 ---------------------------------- ----------------------------------Supplemental cash flow information (note 10)The accompanying notes are an integral part of these financial statements.Deans Knight Income CorporationStatement of InvestmentsAs at December 31, 2010--------------------------------------------------------------------------- Percentage of total fair Par value Average cost Fair value value (1) (2) (2) (3) $ $ $ %Fixed income - CanadianDenominated in Canadian dollarsAir Canada 10.13% 08-01-2015 1,500,000 1,485,690 1,563,750 1.2Cara Operations Ltd. 9.13% 12-01-2015 3,750,000 3,750,000 3,881,250 3.0Garda World Security 9.75% 03-15-2017 2,500,000 2,472,105 2,643,750 2.1Gateway Casinos 8.88% 11-15-2017 2,250,000 2,293,125 2,317,500 1.8Newalta Corp. 7.63% 11-23-2017 3,250,000 3,250,000 3,339,375 2.6North American Energy Partners Inc. (4) 9.13% 8,750,000 8,793,125 9,143,750 7.1 04-07-2017P1 Energy Corp. 12.00% 03-31-2011 5,000,000 5,000,000 5,000,000 3.9Paramount Resources 8.25% 12-13-2017 9,250,000 9,250,000 9,388,750 7.3Sherritt International Corp. 7.75% 10-15-2015 3,500,000 2,718,438 3,753,750 2.9Sherritt International Corp. 7.88% 11-26-2012 1,200,000 903,000 1,273,560 1.0Sure Energy 6.25% 01-21-2014 2,500,000 2,500,000 2,500,000 1.9 ----------------------------------- 42,415,483 44,805,435 34.8 -----------------------------------Denominated in United StatesdollarsCCS Inc. 11.00% 11-15-2015 7,750,000 3,879,423 6,975,876 5.4CHC Helicopter 9.25% 10-15-2020 250,000 253,623 256,731 0.2Gibson Energy ULC 11.75% 05-27-2014 2,000,000 2,220,493 2,198,066 1.7Harvest Operations Corp. 6.88% 10-01-2017 2,500,000 2,547,532 2,548,663 2.0Methanex Corp. 6.0% 08-15-2015 1,000,000 879,586 974,708 0.8Methanex Corp. 8.75% 08-15-2012 3,750,000 4,098,591 3,939,548 3.1National Money Mart 10.38% 12-15-2016 4,000,000 4,363,855 4,276,780 3.3Opti Canada Inc. 7.88% 12-15-2014 2,000,000 1,257,971 1,392,440 1.1Pacific Rubiales Energy Corp. 8.75% 11-10-2016 2,500,000 2,655,612 2,800,664 2.2Tembec Industries 11.25% 12-15-2018 3,750,000 4,015,216 3,934,886 3.1Trinidad Drilling 7.88% 01-15-2019 5,250,000 5,261,477 5,234,704 4.1 ----------------------------------- 31,433,379 34,533,066 27.0 -----------------------------------Total Canadian fixed income 73,848,862 79,338,501 61.8 -----------------------------------Fixed income - United StatesDenominated in United States dollarsABI Escrow Corp. 10.25% 10-15-2018 2,000,000 2,062,000 2,168,228 1.7Beazer Homes USA, Inc. 9.13% 06-15-2018 3,250,000 3,327,056 3,167,801 2.4Calfrac Holdings LP 7.5% 12-01-2020 6,000,000 6,130,329 6,072,033 4.7Cott Beverages Inc. 8.38% 11-15-2017 4,350,000 4,622,109 4,672,631 3.6McMoRan Exploration Co. 11.88% 11-15-2014 2,000,000 2,114,471 2,193,093 1.7Stone Energy Corp. 8.63% 2-01-2017 8,750,000 8,821,638 8,833,291 6.9 -------------------------------------Total United States fixed income 27,077,603 27,107,077 21.0 -------------------------------------Total fixed income 100,926,465 106,445,578 82.8 -------------------------------------Convertible debentures - CanadianDenominated in Canadian dollarsHarvest Energy 7.25% 09- 30-2013 5,500,000 3,635,076 5,643,000 4.4Trinidad Drilling 7.75% 07-31-2012 3,691,000 3,074,609 3,691,369 2.9Convertible debentures - AustralianDenominated Australian dollarsWestern Areas NL 6.38% 07-02-2014 1,872,000 1,879,862 2,010,509 1.6Western Areas NL 8.0% 07-02-2012 1,500,000 1,322,276 1,607,168 1.3 ------------------------------------- 9,911,823 12,952,046 10.2 -------------------------------------EquitySure Energy Inc. - purchase warrants 625,000 - 400,000 0.3Whitecap Resources Inc. - common shares 1,254,167 7,725,669 7,826,002 6.1 ------------------------------------- 7,725,669 8,226,002 6.4 -------------------------------------Investments subtotal 118,563,957 127,623,626 99.4 -------------------------------------HedgesDenominated in United Statesand Australian dollarsForeign currency exchange contracts (note 9) 66,700,000 - 825,824 0.6 ------------------------------------- 118,563,957 128,449,450 100.0 ------------------------------------- -------------------------------------(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 CompanyThe accompanying notes are an integral part of these financial statements.Deans Knight Income CorporationNotes to Financial StatementsDecember 31, 20101 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.Financial instrumentsInvestmentsInvestments are held for trading and are recorded at fair values determined as follows: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 certain 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 year are included in the net realized gain on settlement of foreign currency contracts (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.Public company equitiesPublicly traded equities are recorded at bid prices as quoted on recognized stock exchanges.The amounts at which the Fund's publicly-traded investments could be disposed of currently may differ from carrying value based on market quotes, as the value at which significant ownership positions are sold is often different than the quoted market price due to a variety of factors such as premiums paid for large blocks or discounts due to illiquidity.WarrantsWarrants are recorded at their estimated fair value, using appropriate and accepted industry valuation techniques.The impact of changes in fair value on net income of the Company arising from changes in estimated fair value for investments is recorded in the statement of operations.Cash and cash equivalentsCash and cash equivalents are accounted for at amortized cost. They consist of cash and deposits with maturities, at the time of purchase, of three months or less and are held with a Canadian chartered bank.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.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 it is likely that a payment will be required to be made.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 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 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 balance sheet 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 year ended December 31, 2010 was 10,537,263 (December 31, 2009 - 8,335,545). 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 reclassified 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 2,877,873Shares issued for payment of interest owed on convertible debenture - - 8,227,260 215,213Share consolidation (58,941,083) - (131,700,490) - -------------------------------------------------- 154,702 480,743 345,671 3,093,086Shares 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 December 31, 2010 10,191,592 96,273,343 345,671 3,093,086 -------------------------------------------------- --------------------------------------------------Total common shares outstanding at December 31, 2009 and December 31, 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 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 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.Contributed surplusThe contributed surplus balance did not change during the year, and consists of: December 31, December 31, 2010 2009 $ $Surplus related to stock compensation, warrants and options associated with common shares 8,030,295 8,030,295Surplus relating to warrants associated with previously issued preferred shares 1,874,209 1,874,209 ---------------------------- 9,904,504 9,904,504 ---------------------------- ----------------------------5 Retained earningsThe changes in retained earnings for the year were as follows: $Deficit - December 31, 2008 (13,159,390)Increase in net assets from operations 36,870,408Dividends paid from net investment income (4,300,257) ------------Retained earnings -December 31, 2009 19,410,761Increase in net assets from operations 22,033,536Dividends paid from net investment income (7,371,869) ------------Retained earnings -December 31, 2010 34,072,428 ------------ ------------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 year ended December 31, 2010, management fees totalled $2,110,657 (December 31, 2009 - $1,361,226). At December 31, 2010, $599,474 (December 31, 2009 - $476,700) was owed to the Investment Advisor, which was included in accounts payable and accrued liabilities in the statement of net assets at December 31, 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 year ended December 31, 2010, the Company incurred $30,195 (December 31, 2009 - $ 355,000) in legal services and disbursements received from this related party. At December 31, 2010, accounts payable and accrued liabilities include $1,355 (December 31, 2009 - $550) due 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 year endedDecember 31 was as follows: 2010 2009 $ $Proceeds from sale of investments 107,386,034 37,977,722 ----------------------------Investments at cost - Beginning of year 100,510,397 -Add: Cost of investments purchased 106,283,479 125,360,814 ---------------------------- 206,793,876 125,360,814Less: Investments at cost - End of year (118,563,957) (100,510,397) ----------------------------Cost of investments sold 88,229,919 24,850,417 ----------------------------Net realized gains on investments sold 19,156,115 13,127,305 ---------------------------- ----------------------------Net realized gains on investments sold consist of: 2010 2009 $ $Realized gains on securities sold 15,928,417 5,590,551Realized gains on settlement of foreign currency contracts 3,227,698 7,536,754 ---------------------------- 19,156,115 13,127,305 ---------------------------- ----------------------------8 TaxationUncertainty of deductibility of tax lossesPrior to the reorganization and change in business as discussed in notes 1 and 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 $20,747,249 (December 31, 2009 - $15,647,415), representing $1.97 per common share at December 31, 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 $6,550,000 (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: December 31, December 31, 2010 2009 $ $Future tax assetsNon-capital loss carry-forwards - 5,150,041Research and development expenditures 8,467,000 8,599,750Investment tax credits 6,032,450 5,677,600Share issuance costs 959,100 1,316,448Property, plant and equipment and intangible assets - 490,500 ----------------------------Total gross future tax assets 15,558,550 21,234,339Valuation allowance (8,908,550) (13,034,339) ----------------------------Net future tax asset 6,550,000 8,200,000Less: current portion (2,150,000) (2,210,000) ---------------------------- 4,400,000 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, that reinvested funds will achieve an 8% yield, and that investments maturing after April 30, 2014 will be sold at their current value.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, significant estimates are required to compute income tax balances. As at December 31, 2010, the Company has accumulated scientific research and experimental development expenditures in the amount of $33,460,000 available for carry-forward indefinitely. The Company also has accumulated approximately $7,097,000 of unclaimed federal investment tax credits, which expire as follows: Investment tax credits $Year of expiry2018 265,0002019 990,0002020 1,872,0002021 2,483,0002022 298,0002023 187,0002024 496,0002025 506,000 ------------- 7,097,000 ------------- -------------Reconciliation of income tax expenseThe reconciliation of income tax computed at the statutory tax rate toincome tax expense, using a 28.5% statutory tax rate (2009 - 30%), is: December 31, December 31, 2010 2009 $ $Increase in net assets from operations before taxes 23,683,536 30,362,908Statutory tax rate 28.5% 30% -----------------------------Income tax expense at statutory rates 6,749,808 9,108,872Use of prior year losses (6,124,935) (8,763,863)Use of scientific research and experimental development expenditures (267,551) -Changes in valuation allowance 1,650,000 (8,200,000)Future tax benefit related to initial public offering costs - 1,692,500Current tax deductions for offering costs (357,322) (345,009) -----------------------------Income tax provision (recovery) 1,650,000 (6,507,500) ----------------------------- -----------------------------9 Financial instrumentsThe following tables illustrate the classification of the Company'sfinancial instruments within the fair value hierarchy: Financial assets at fair value - December 31, 2010 -------------------------------------------------- Level 1 Level 2 Level 3 Total $ $ $ $Corporate debt - 91,969,703 14,475,875 106,445,578Convertible debentures - 9,334,369 3,617,677 12,952,046Equity 7,826,002 - 400,000 8,226,002Foreign currency - forward contracts - 825,824 825,824 -------------------------------------------------- 7,826,002 102,129,896 18,493,552 128,449,450 -------------------------------------------------- -------------------------------------------------- Financial assets at fair value - December 31, 2009 -------------------------------------------------- Level 1 Level 2 Level 3 Total $ $ $ $Corporate debt - 75,338,513 11,616,418 86,954,931Convertible debentures - 15,636,660 10,561,008 26,197,668Foreign currency forward contracts - 92,441 - 92,441 -------------------------------------------------- - 91,067,614 22,177,426 113,245,040 -------------------------------------------------- --------------------------------------------------All investments remained at their respective levels within the fair valuehierarchy during the year.The following table reconciles the Company's Level 3 fair valuemeasurements: Fair value measurements of Level 3 inputs Corporate Convertible debt debentures Equity Total $ $ $ $Balance - December 31, 2008 - - - -Purchases 9,671,316 10,364,931 - 20,036,247Unrealized appreciation included in net gain on investments 1,945,102 196,077 - 2,141,179Balance - December 31, 2009 11,616,418 10,561,008 - 22,177,426Purchases 7,500,000 1,879,862 - 9,379,862Sales (6,061,608) (17,921,531) - (23,983,139)Unrealized appreciation included in net gain on investments 1,421,065 9,098,338 400,000 10,919,403 --------------------------------------------------Balance - December 31, 2010 14,475,875 3,617,677 400,000 18,493,552 -------------------------------------------------- --------------------------------------------------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 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 islisted as follows: As a % of net assets ----------------------------- December 31, December 31, 2010 2009Credit ratingBB 10.7 18.3B 36.0 25.1CCC 21.3 10.3CC 1.0 -Not rated(i) 20.0 34.2 ----------------------------- 89.0 87.9 ----------------------------- -----------------------------(i) Unrated debt securities consist primarily of equity securities, convertible debentures and promissory notes in publicly traded companiesCredit ratings are obtained from various credit rating agencies and sources.Where one or more rating is obtained for a security, the lowest rating hasbeen used.The Company's credit risk exposure by sector on its investments is asfollows: As a % of net assets ----------------------------- December 31, December 31, 2010 2009SectorEnergy 57.1 56.2Materials and metals 6.0 16.9Consumer goods 9.4 2.8Services 3.6 -Chemicals 3.4 -Financial services 3.0 -Industrial/manufacturing 2.2 4.5Forestry 4.3 0.8Telecommunications - 4.4Precious metals - 2.3 ----------------------------- 89.0 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 primarily 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: Fair value ---------------------------- December 31, December 31, 2010 2009 $ $MaturityLess than 1 year 5,825,824 1,942,4411 - 3 years 16,154,645 42,986,3543 - 5 years 27,443,442 35,149,061Greater than 5 years 70,799,537 33,167,184 ---------------------------- 120,223,448 113,245,040 ---------------------------- ----------------------------As at December 31, 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 $4,900,000, or approximately 3.4% of net assets (December 31, 2009 - $3,500,000, 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 December 31, 2010 ------------------------- Cash and Foreign cash exchange Impact on Investments equivalents contracts Total net assets $ $ $ $ $CurrencyUnited States dollars 61,640,143 5,024,395 916,045 67,580,583 3,379,029As a % of net assets 43.1 3.5 0.6 47.3 2.4Australian dollars 3,617,677 - (90,221) 3,527,456 176,373As a % of net assets 2.5 0.0 -0.1 2.5 0.1 As at December 31, 2009 ------------------------- Cash and Foreign cash exchange Impact on Investments equivalents contracts Total net assets $ $ $ $ $CurrencyUnited States dollars 71,989,931 1,259,819 18,727 73,268,477 3,663,424As a % of net assets 55.9 1.0 0.0 56.9 2.8Australian dollars 3,061,008 - 73,714 3,134,722 156,736As a % of net assets 2.4 - 0.1 2.5 0.1At December 31, 2010, the Company had outstanding foreign exchange contracts to sell US$63,000,000 and AUS$3,700,000 against future commitments at exchange rates ranging between 1.00675 and 1.01055 for US dollar foreign exchange contracts and 0.99315 for the AUS dollar foreign exchange contract. Those contracts have maturities ranging up to January 26, 2011 and are with AAA rated Canadian bank and counterparties.10 Supplemental cash flow information Year ended December 31, ------------------------- 2010 2009 $ $Non-cash operating transactionsProceeds from investments on conversion of debenture 17,921,531 -Cost of investments on conversion of debenture (17,921,531) -Non-cash financing transactionsNon-voting common shares issued on conversion of debenture (note 4) - 2,877,873Voting common shares issued on conversion of debenture (note 4) - 480,742Non-voting common shares issued for payment of interest on debenture (note 4) - 215,213Future income tax benefit from offering costs (note 4) - 1,692,50011 Capital managementThe capital of the Company is divided into 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 exclude 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 year ended December 31, 2010, the Company made dividend payments of $7,371,869 (December 31, 2009 - $4,300,257).The Company intends to continue paying a monthly dividend of $0.0583 per voting and non-voting common share for the three months ending March 31, 2011, 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. December 31, December 31, 2010 2009 $ $Net asset value per share 13.65 12.23Canadian GAAP adjustments (0.05) (0.02)Net assets per share 13.60 12.2113 Subsequent eventsOn January 6, 2011, the Company announced a monthly dividend of $614,322, or $0.0583 per common share, payable on each of January 31, 2011, February 28, 2011 and March 31, 2011.FOR FURTHER INFORMATION PLEASE CONTACT: Craig LangdonDeans Knight Income CorporationChief Executive Officer and Director(604) 669-0212ORMark MylesDeans Knight Income CorporationChief Financial Officer(604) 669-0212www.dkincomecorp.com